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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, presented to the Senate Standing Committee on National Finance, Ottawa, Ontario, 2 November 2011.
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Mark Carney: Retail price differentials between Canada and the United States Opening statement by Mr Mark Carney, Governor of the Bank of Canada, presented to the Senate Standing Committee on National Finance, Ottawa, Ontario, 2 November 2011. * * * Good evening. Tiff and I are pleased to be here with you today to discuss retail price differentials between Canada and the United States. The mandate of the Bank of Canada is to enhance the well-being of Canadians by contributing to sustained economic growth. 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. In Canada, this is achieved through an inflation-control targeting framework. Inflation-control targeting has been a cornerstone of monetary policy in Canada since its introduction in 1991. Since 1995, the target range has been 1 to 3 per cent, with the Bank’s monetary policy aimed at keeping inflation at the 2 per cent target midpoint. It is important to stress that the target is for total CPI inflation, which is the best measure of the overall cost of living for Canadians. We do not target or try to control prices of individual goods and services. With 2 per cent inflation, there will always be some prices rising more quickly and others more slowly. Central to a market-based economy is the role of relative price signals in allocating resources. To understand the evolution of CPI inflation, the Bank looks at the forces shaping various prices, one of which is consumer price differentials between Canada and the United States. We also examine the role played by the exchange rate in price gaps, about which I will speak in a moment. We look at both of these, and the factors that drive them, to understand how prices are set in Canada which, in turn, contributes to our analysis of the inflation expectations of Canadian households and businesses and, ultimately, to our ability to fulfill the Bank’s mandate. At the Bank, we use two sources of information to estimate the size and evolution of retail price differentials between Canada and the United States. The first is the consumer price index information from Statistics Canada and the U.S. Bureau of Labor Statistics. In particular, we examine the ratio of the Canadian CPI to the U.S. CPI for three price categories: autos, other durables and clothing. These ratios provide information about the evolution of prices in Canada relative to prices in the United States. On their own, however, they do not tell us the absolute dollar amount of price gaps between the two countries. To assess the price-gap level, we use information about the prices of specific goods in both countries gathered from an informal Internet survey conducted by Bank of Canada staff. We record the prices of a list of identical goods in Canada and the United States at the same retail outlet. U.S. dollar prices are converted into Canadian dollars using the bilateral exchange rate for that day. Using these two sources of information, the Bank of Canada’s best estimate is that the Canada-U.S. retail consumer-goods price differential was 11 per cent in September, down from 18 per cent in April. In other words, prices of a set of comparable goods in Canada are an average of 11 per cent higher than the prices of these same goods in the United States. I caution that these are estimates and there is some uncertainty around them. An important question is why has the gap not narrowed more for similar goods, given the increase in the value of the Canadian dollar. For your consideration, allow me to discuss BIS central bankers’ speeches some of the possible factors, both macroeconomic and structural, that influence the prices of goods and services in both countries. First, cyclical issues may be responsible for some differences between Canadian and U.S. prices. Unexpected economic weakness in one country could lead to an undesirable buildup of inventories and result in local discounting of prices. In addition, as long as markets are partially segmented across international borders, market power may enable firms to respond to local demand conditions—possibly resulting in lower prices in areas with weaker demand. Secondly, from a macro perspective, prices take time to adjust. Importantly, this is not only true in response to the exchange rate, but also to anything that changes the economic environment (and this is why there are lags in the effect of monetary policy). In addition to the macro elements, there are structural factors, including profit margins and underlying costs, that influence the prices of goods and services and that can also contribute to the gap in prices in Canada and the United States. Operating profit margins for both the wholesale and retail sectors will have an impact on the prices of consumer goods in retail outlets. One possible reason that margins have remained elevated in Canada may be that the retail environment is more concentrated in Canada than in the United States. In Canada, the top four retailers have a 28 per cent market share, compared with only 12 per cent in the United States. On the cost side, there are a number of factors that are important for understanding the differences in prices in Canada and the United States. Labour costs tend to be higher in Canada than in the United States. For instance, in the retail sector, total compensation per hour is higher in Canada. Despite this, retail- and wholesalesector employment is higher as a share of total employment in Canada, even though retail and wholesale trade in Canada each represent a smaller share of real GDP. The latter reflects Canada’s productivity performance in the retail sector, which has lagged that of the United States. This is partly a result of a much lower level of capital intensity and lower total factor productivity growth. Total factor productivity refers to how labour and capital are combined to create efficiency gains. Here, industry structure appears to matter, with larger productivity gains from investment at chain stores than individual stores. Following 1995, productivity surged in the United States, with investment in new equipment and organizational change. In Canada, these effects do not seem to have been experienced to the same degree, perhaps due to the more localized nature of Canadian markets. Transportation is another factor on the cost side. While fuel costs are only a portion of total transportation costs, the difference in gasoline taxes between the two countries makes gas more expensive in Canada. Lower population density in Canada may also contribute to higher transportation costs on a per-item basis. All of these factors and other domestic value-added services, such as marketing, are priced in local currency. Thus, when the value of the exchange rate moves, these costs to Canadian retailers, which must be paid in Canadian dollars, do not change. For imported goods, reflecting the smaller size of the Canadian market, the price paid by a Canadian importer of a good may be higher than that paid by an American importer. The Canadian market is roughly one tenth the size of the U.S. market, suggesting a much smaller potential for economies of scale. While this may not be as much of an issue for large retail chains with presence in both markets, smaller mostly domestic retail firms could be affected. Finally, given all of these factors just discussed, allow me to turn to the role played by the exchange rate in price differentials between Canada and the United States. BIS central bankers’ speeches As mentioned earlier, consumer prices tend to be sticky—this is true on both sides of the border. More broadly, the segmentation of international markets, in part due to the higher costs of shopping abroad, creates limits to competitive pressures. In addition, paying attention and adjusting to fluctuations in the exchange rate requires time and energy. It is costly. When fluctuations in the exchange rate are relatively small, not all firms and consumers tend to pay close attention. It makes sense to focus attention where it matters most. That is one reason why prices are only adjusted over time and price gaps persist. However, when the movements in the exchange rate are particularly large, they attract more attention and the adjustments are much faster, which we saw in the fall of 2007. The most useful illustration of these phenomena is the behaviour of online book prices. These are often completely homogeneous goods on both side of the border. The cost of changing prices for an online retailer should be minimal. In addition, it is difficult to think of an easier case for consumers to take advantage of price differentials: comparing prices is just a matter of visiting different websites, there is no constraint or tariff involved when ordering from abroad, and transportation costs are known. Despite all this, while online book prices do change frequently, they typically do not respond quickly to fluctuations in the exchange rate. However, in the fall of 2007, they did adjust to the strong Canadian-dollar appreciation. Typically, exchange rate movements tend to be reflected quickly in prices for only a narrow range of goods that are homogeneous in nature, e.g. fruits, vegetables, gasoline and meat prices. For other goods and services, there is no apparent short-run pass-through. The greater the value added in Canada to a good or service, the smaller the role played by the exchange rate in its price. However, estimates of pass-through at a more aggregated level, such as core CPI or total CPI, are quite low. Estimated pass-through is about 3 per cent for core inflation and 4 per cent for total inflation. To elaborate further, this means that a 10 per cent rise in the dollar would be expected to lower the level of total CPI by 0.4 per cent. Similar to the experience of many countries, exchange rate pass-through has declined in Canada in the last 20 years. Some possible explanations include: better-anchored inflation expectations associated with the conduct of monetary policy and increased credibility, and the changing composition of trade (e.g. switching to different goods as relative prices change). I trust these comments provide some insights to the underlying dynamics of Canadian-U.S. price differentials. With that, Tiff and I would be pleased to take your questions. 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 and Chairman of the Financial Stability Board, to the Canada-United Kingdom Chamber of Commerce, London, 8 November 2011.
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Mark Carney: Global liquidity Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Canada-United Kingdom Chamber of Commerce, London, 8 November 2011. * * * Introduction It is a pleasure to be in London and an honour to speak in Drapers’ Hall. This magnificent building was for centuries where merchants met to trade cloth. During the 15th and 16th centuries, the Drapers’ Company was one of the most important City companies. It had extensive powers to regulate the woollen cloth trade in the City of London – setting the standard measure by which all cloth was sold and controlling its sale at fairs held in the City. Dealers could only sell cloth to a freeman of the Company and, as their portraits on these walls attest, it was a very profitable monopoly for those on the inside. It was, however, decidedly less advantageous for those on the outside, and so the stranglehold of the Drapers’ Company eventually eroded. By the 17th century, the trade began to move out of the City and the companies’ powers of regulation declined. Eventually, freed from the restrictions of the guilds, a highly competitive, global textiles industry became one of the foundations of the British Empire. While wool had been a tidy little earner, textiles helped deliver a century of unprecedented prosperity. There is an analogy to London’s position in global finance. The City re-established its preeminence following the deregulation of the closed shop of British finance in the mid-1980s. The subsequent reduction of capital controls, first across advanced and then emerging economies, spurred an explosion of cross-border capital flows. In an era when trade expanded sevenfold, capital flows would increase more than thirty times. Today, the City is the centre of global finance, and its fortunes are tied to cycles in the global economy, and more particularly to large, sometimes abrupt, fluctuations in cross-border financial flows. This is my subject today: how global liquidity cycles affect financial stability and economic growth, and what policy can do about it. 1 Over the past five years, global liquidity has swung wildly from the exuberant surge that fed a cavalier “search for yield” during the Great Moderation to the severe retreat that prompted the desperate “rush for shelter” in the aftermath of Lehman. In response to the massive monetary and fiscal policy stimulus unleashed following that debacle, liquidity flooded back, boosting asset prices and bolstering growth across the globe. Now the cycle is again turning. The ongoing deleveraging of the European banking system is reducing global liquidity, with cross-border credit being pulled from many emerging markets and some U.S.-dollar asset classes. Market-making activity is becoming thinner, and private financing is slowing across the world. The volatility of global liquidity in recent years underscores the value of the structural and cyclical policies that can dampen these cycles and channel the flows to their most productive uses. This speech draws heavily on the forthcoming report, “Global Liquidity – Concept, Measurement and Policy Implications,” prepared by a group of the Committee on the Global Financial System chaired by Jean-Pierre Landau of the Bank of France. BIS central bankers’ speeches Defining global liquidity Global liquidity is an amorphous concept. The Usual Suspect for any event or dynamic too complicated to explain, global liquidity is the Keyser Söze of international finance. It has no agreed definition and, as a consequence, there has been no coherent policy approach to tame its more violent tendencies. At its core, liquidity represents the ease with which financial institutions, households and businesses can obtain financing. 2 Global liquidity cannot be understood by simply summing domestic measures of financial conditions. The international components of liquidity (such as cross-border lending) will affect market and macroeconomic outcomes in recipient countries, and can have a disproportionately large role in fluctuations in financial stability. To capture all the dimensions of global liquidity requires a combination of price and quantity measures. Price indicators, such as the general level of interest rates or credit spreads, provide information about the conditions under which liquidity is provided, while quantity measures, such as credit aggregates, show the degree to which such conditions translate into the build-up of risks. Official liquidity Overall levels of global liquidity are the product of the levels of official and private liquidity and the complex interactions between the two. Official liquidity is funding that is unconditionally available to settle claims through monetary authorities. It can only be created by central banks. Core official liquidity is base money, or the sum of currency in circulation and funds held by financial institutions at the central bank. Official liquidity has traditionally been small relative to economic activity. Before the financial crisis, it was about 5 per cent of GDP in the United Kingdom and the United States. In recent years, the central banks of the crisis economies have roughly tripled base money to offset the retreat in private liquidity. In addition to their monopoly on the creation of official liquidity, central banks employ various facilities to redistribute liquidity in their domestic markets. During periods of stress, repo facilities take in liquidity from risk-averse private institutions and re-offer it (against good collateral) to other private institutions. It is in this way that the European Central Bank (ECB) has prevented the most severe effects of the shortages in funding liquidity plaguing European banks. Partly as a result of the scale of concerns about counterparty risk, the ECB’s balance sheet has risen from 13 to about 20 per cent of GDP since the start of the crisis. Although unprecedented, the combination of the ECB’s bold moves and €4 trillion in unencumbered collateral at European banks should ensure that there is no European equivalent of Lehman. However, measures that avoid disaster are not necessarily sufficient to promote recovery. There are also various ways public authorities can provide the private sector with access to official liquidity in foreign currency – the most traditional of which is drawing on foreign exchange reserves. More recently, central banks have added bilateral swap lines to their arsenals. In the extreme, these resources could be supplemented by conditional loans from the International Monetary Fund (IMF). For present purposes, it is important to distinguish between funding and market liquidity. Market liquidity is the ability to trade an asset or financial instrument at short notice with little impact on its price. Funding liquidity refers to the ability to raise cash either through the sale of an asset or by borrowing. These concepts of liquidity are closely interlinked. BIS central bankers’ speeches Private liquidity Overall global liquidity conditions are the result of complex interactions among several factors, including macroeconomic policies (such as the monetary policy stance and exchange rate regime), microprudential regulations (such as capital and liquidity rules), financial market innovation and risk appetite. A key determinant is the financial sector’s willingness to provide cross-border financing. This can take the form of direct lending, the provision of market liquidity by banks to securities markets through market making, or funding liquidity to other financial institutions through repos. The conditions under which these intermediaries can fund their own balance sheets, in turn, depend on the willingness of other private sector participants to provide funding or market liquidity. These interrelationships and changes in risk appetite mean private liquidity is highly cyclical. In good times, when economic volatility is low, risk appetite and leverage increase. The resulting easing in financial conditions promotes a surge in private liquidity with greater maturity and currency mismatches at financial institutions, compressed risk premia, faster credit growth in the real economy, and marked run-ups in asset prices. Higher asset prices in turn further promote funding liquidity as the cycle progresses. These dynamics can be particularly pronounced if expectations develop of prolonged periods of unusually low interest rates. Moreover, some of the policy responses intended to mitigate the effects of liquidity shortages can themselves affect the patterns of capital flows, the prices of financial assets and, reflexively, the creation of further global liquidity. For example, the massive, predictable reserve buildup by Asian central banks has dampened longer-term interest rates, promoted carry trades and fed global liquidity creation. Efforts by some to selfinsure have made the system as a whole more vulnerable. When the cycle reverses, deleveraging amplifies the downswing. During periods of heightened economic uncertainty – such as we are currently experiencing – sharp declines in risk appetite reduce funding liquidity, forcing market participants to sell riskier assets to raise liquidity. Such fire sales can lead to a generalized decline in asset prices, which further raises investors’ funding liquidity risk through margin calls. In the extreme, widespread uncertainty about the viability of banks can lead to a total drying up of private funding, with significant adverse effects on the financial system and the broader economy. Global liquidity is intensely procyclical, with the complacency fostered by periods of excessive global liquidity contributing to the buildup of large mismatches across currencies, maturities and countries. History suggests that the greater the reliance on cross-border liquidity, the more extreme these cycles can be, and the larger the disruption when they turn. Recent developments in global liquidity With increasing financial integration, the impact of global liquidity on domestic financial and economic conditions is growing. 3 The recent Irish experience demonstrates how it can amplify the cyclical dynamics of domestic credit and asset prices. Direct cross-border flows of bank credit to Irish non-financial corporations increased at about a 40 per cent annual rate during the three years leading up to the crisis. 4 Together with strong lending from domestic sources, these cross-border flows led to sharp increases in private domestic debt and unsustainable growth in house prices and housing sector activity. Gross cross-border capital inflows rose from less than 5 per cent of global GDP in the mid-1980s to about 20 per cent before the financial crisis. By 2008, the sum of direct cross-border lending and cross-border sources of bank funding accounted for more than half of total bank credit to non-banks in Ireland. BIS central bankers’ speeches The Irish experience was not unique. Globally, cross-border bank credit (particularly interbank funding) grew rapidly between 2003 and 2007, reaching annual rates of 20 per cent by the eve of the crisis. This surge fed the buildup of large currency mismatches, particularly for European banks in U.S. dollars. After the onset of the crisis, cross-border interbank lending fell sharply, reducing funding liquidity, forcing asset fire sales and further reducing overall private liquidity. Although central banks stepped into the breach with a host of facilities, the damage to both confidence and broader funding was severe. Given the scale of the deleveraging process in the real economy, the change in central bank liquidity (base money) in the United States, United Kingdom and euro area has covered only about 70 per cent of the decline in private credit from its pre-crisis peak. Other cross-border credit cycles illustrate how vulnerabilities can arise in environments like the present. Recall that in the late 1990s, the Japanese banking system, undercapitalised and determined to delever, triggered the reversal of the capital inflows that had helped fuel the Asian boom. The impact of European deleveraging on global liquidity Current difficulties in the European banking sector should be seen in this light. Stresses there could trigger sharp swings in global liquidity, with consequences across financial systems and economies. Funding conditions in Europe have tightened markedly in recent months as a result of rising concerns over sovereign risk. The 3-month EURIBOR-OIS spread has more than tripled and bank access to longer-term unsecured financing has been sporadic at best. The retreat of cross-border flows has been the determining factor. For example, U.S. money market funds have sharply reduced their exposures to European banks. As a result, U.S.-dollar funding pressures have been particularly acute, prompting the ECB to extend its U.S.-dollar liquidity facilities. The deterioration in funding markets in Europe has had important spillover effects on broader European financial conditions. Lending standards for businesses and households have tightened significantly and, partially as a consequence, economic momentum has slowed. Indeed, despite the major steps taken in recent weeks by European authorities, the Bank of Canada now expects the euro area to experience at least a brief recession as a result. The effects are not limited to Europe. Global financial conditions have tightened significantly. Market-making activity has decreased, with U.S. primary dealer inventories of corporate bonds down about 40 per cent since April to a level of about one-quarter of their pre-crisis peak. More importantly, relative to levels over the previous two years, new issuance volumes have fallen by about 80 per cent in the U.S. high-yield market, and roughly 25 per cent in investment-grade corporate markets over the past three months. As global liquidity recedes, volatility is increasing and activity falling. The effect on the real economy will soon be felt. Policy implications Authorities are closely monitoring these developments and will act if necessary to offset them. 5 In the absence of decisive actions to address the underlying sovereign problems, there are several alternatives to mitigate the effects. The recent communiqué of G-20 Finance Ministers and Central Bank Governors committed the G-20 to continued efforts to assess developments in global liquidity conditions (15 October 2011). BIS central bankers’ speeches The first is to limit the scale of deleveraging itself. The severity of the downturn will depend in part on how European banks delever. The new requirement to raise core Tier 1 capital to 9 per cent by next June can be met through a combination of retained earnings, capital increases and asset sales. In the extreme, if only asset sales were used, up to €2.5 trillion of disposals would be required in coming months. Based on last year’s earnings and assuming no dividends are paid, the lower bound for asset sales would be €1.4 trillion. These will likely be concentrated in non-core businesses – notably in emerging markets and in U.S. dollars. Perhaps not surprisingly, in recent months, capital flows to emerging markets have slowed and, in some cases, reversed. Anticipation of this trend, combined with a generalised decrease in risk appetite, could further feed this dynamic. Now may be a time for Asian authorities to draw on official reserves to offset the withdrawal of private liquidity. The advantage for European banks of selling U.S.-dollar assets is obvious. Doing so would reduce the funding currency mismatch that has plagued them for the past several years. Non-European creditors are seeing opportunities in structured products, trade and project finance, as well as conventional corporate lending facilities. This will displace new credit creation in the United States. One way European authorities could reduce these spillovers is to require European banks to meet at least part of their requirements by raising private capital, including high-trigger contingent capital. The latter would limit the dilution of existing shareholders, while providing a loss absorbing cushion. The current situation is ideally suited for this instrument since the capital is being raised for an extreme tail event (losses on highly rated sovereign debt) – the public nature of which would involve no risk of regulatory forbearance. The second line of defence involves co-operative measures to provide foreign currency liquidity. In recent years, central banks, led by the U.S. Federal Reserve, have instituted swap lines to redistribute U.S.-dollar official liquidity in order to address currency mismatches in the financial sector. 6 In their first round in 2008–09, U.S.-dollar swaps proved very effective in containing currency basis swap rates and OIS funding spreads, before ultimately helping to end the period of liquidity destruction and stabilising global financial markets. Since the intensification of the European crisis this past summer, the swap lines have been supplemented by the reintroduction of unlimited 3-month U.S.-dollar liquidity operations at the ECB, the Bank of Japan, the Bank of England and the Swiss National Bank. 7 Given the close relationship between global and domestic liquidity, central banks also stand ready to activate domestic facilities, if required. 8 Country-specific or regional liquidity shocks may also be addressed through IMF facilities. The IMF is already playing an important role in the peripheral country programs, which could be expanded through further conventional, conditional lending if the situation required. These facilities have been implemented flexibly with country coverage and the liquidity amounts adjusted on a timely basis, depending on the prevailing market conditions. Importantly, they have also been designed to limit moral hazard, with access at a penalty rate to ensure that market participants return to private sources of liquidity as market conditions improve. These banks will offer unlimited U.S.-dollar liquidity at a fixed rate of OIS plus 100 basis points in three operations, which span year-end. These central banks were already providing 7-day unlimited U.S.-dollar liquidity and are continuing to do so. For example, in response to the sharp, synchronous global recession, the Bank of Canada almost doubled our balance sheet to provide the Canadian financial sector with exceptional Canadian-dollar liquidity. We stand ready to take similar steps if the international spillovers of the European situation prove severe. At this stage the limited direct links between our two financial sectors suggest that this is unlikely unless there is a more generalised reduction in risk appetite affecting global markets. BIS central bankers’ speeches However, the IMF can only redistribute liquidity. It cannot lean against the retreat of private liquidity by creating official liquidity. The final line of defence is to adjust monetary policy if the outlook for economic activity and inflation warrant. For those economies at the zero lower bound for their policy interest rate, this would likely mean the direct provision of additional official liquidity through quantitative easing, as the Bank of Japan and the Bank of England have done in recent weeks. Conclusion In conclusion, recent history has amply demonstrated that global liquidity has an important impact on financial stability and economic growth. Global liquidity has fluctuated wildly over the past five years, and we are on the cusp of another retrenchment. There are steps that can be taken to mitigate, but not eliminate, the negative effects of the current wave. How European banks choose to delever will determine which ones authorities around the world need to take. Central banks remain best placed to address future surges and shortages in global liquidity. Through regular private discussions, central banks understand each others’ economic outlooks and reaction functions, thus providing the context within which they can set their own policy. At our most recent G-20 meeting, we committed to redouble these efforts, beginning with improved monitoring of global liquidity conditions. Although central bank measures can help address current volatility, such a situation is hardly ideal. Over the medium term, the continuation of such extreme liquidity cycles could ultimately threaten open capital markets and a free trading system if not better addressed. There is a premium on improved oversight and regulations that reduce the procyclicality of global liquidity and make the system more resilient. The G-20’s financial reform agenda, once fully implemented, will dampen global private liquidity cycles. Measures that increase the resilience of financial institutions, such as the new Basel III capital and liquidity standards, will reduce the probability and frequency of a sudden liquidity shock. Measures that reduce the procyclicality of the financial system will help stabilise global liquidity flows. Key elements in this regard include countercyclical capital buffers, the implementation of more resilient financial market infrastructure, reductions in the variability of repo margins, and other macroprudential policies such as loan-to-value ratios in property markets. Of course, the impact of the financial reforms will be weakened to the extent that new regulations divert activity to unregulated parts of the financial system. Particularly in boom periods, non-regulated institutions tend to take on an increasing share of intermediation and cross-border credit provision. This is why enhanced supervision and regulation of shadow banking will be one of the top priorities for the Financial Stability Board in the coming months. In this respect, we need to heed one of the lessons of this Hall: it will do no good to tightly regulate a market only to see the bulk of activity flee beyond our reach. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the MaRS Discovery District, Toronto, Ontario, 14 November 2011.
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Mark Carney: Bank note launch Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the MaRS Discovery District, Toronto, Ontario, 14 November 2011. * * * It is a great pleasure to be here in the MaRS Discovery District, where science and innovation meet. I am here to announce the issue of the new $100 bank note which is available, as of today, in banks across the country. We are very proud of our innovative polymer bank notes. They are more secure, more economical, and better for the environment than any we have issued previously. These notes are also potent symbols of our rich heritage. The design of the $100 bank note celebrates Canadian innovation in medical research, including the discovery of insulin to treat diabetes. We are honoured to issue this note on the site where Banting and Best conducted their groundbreaking research almost a century ago. Many forget that diabetes was once a death sentence. The discovery of insulin changed that. It was at that desk, Sir Frederick Banting’s desk, where science and innovation met and the lives of hundreds of millions of people changed. Today’s date is no coincidence. November 14 is World Diabetes Day and the 120th anniversary of Sir Frederick Banting’s birth. This $100 note is a tribute to Canadian researchers who have left their mark in many areas. Allow me to mention the transformational work of John Hopps, who invented the pacemaker in 1950. He developed this life-saving device at the University of Toronto's Banting Institute, located across the street from here. This spirit of innovation carries on today and so the note also celebrates the scientists who continue to make our world a better place by improving the lives of many. Here in MaRS, medical professionals are mapping the human genetic code as well as tackling some of the most daunting medical challenges of our time, including cancer and macular degeneration. These polymer notes don’t just celebrate innovation; they are themselves at the frontier of bank note technology. 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. There is no other currency like it anywhere in the world. These new notes contain a unique combination of transparency, holography and other sophisticated security elements. In addition to impressive security features to stay ahead of counterfeiting threats, these bank notes will last longer – at least two-and-a-half times longer than paper – and will therefore be more economical. These bank notes are also green. Their environmental footprint is smaller than that of the old currency made from cotton-based bank note paper. Once these new notes are removed from circulation, they will be recycled into other products right here in Canada. Since the new notes were unveiled last June, Bank of Canada staff across the country have been training the millions of cash handlers and tens of thousands of police officers about how to check the security features of the notes. This training, of course, is ongoing. The RCMP continues to be a strong and committed partner in the fight against counterfeiting. Reports of the death of cash are greatly exaggerated: Our research shows that cash is used for more than half of all shopping transactions. Canadians need a currency they can trust. BIS central bankers’ speeches That is why we are launching today the most secure and advanced note series in the Bank’s history. In short, these new bank notes are a 21st century innovation in which all Canadians can take pride. We are honoured to launch them here at MaRS, with its links to past glories, current successes, and the promise of future Canadian medical innovation. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Board of Trade of Metropolitan Montreal, Montreal, Quebec, 23 November 2011.
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Mark Carney: Renewing Canada’s monetary policy framework Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Board of Trade of Metropolitan Montreal, Montreal, Quebec, 23 November 2011. * * * Over the past twenty years, Canadians have enjoyed a more stable and prosperous economic environment. Even during the recent crisis, the Canadian economy proved more resilient and recovered faster than our advanced-economy peers. The strength and relative stability of our economy have been due, in part, to Canada’s inflation-targeting regime, which was first adopted in 1991. Earlier this month, the Government of Canada and the Bank of Canada jointly announced the renewal of the target for five more years – re-affirming its important role in enhancing the well-being of Canadians. In my remarks today, I will discuss what went into this decision, while addressing three important issues that the crisis brought into sharp relief. I will conclude by providing a brief summary of how we apply this framework to today’s circumstances. Canada’s monetary policy regime has proved its worth in both turbulent and tranquil times The effectiveness of Canada’s inflation-targeting regime is well established. Since its adoption, inflation has averaged 2 per cent, as measured by the consumer price index (CPI), and its standard deviation has fallen by roughly two-thirds, compared with the 1970s and 1980s. Greater price stability has allowed Canadians and their businesses to manage their finances with greater confidence. Interest rates have also been lower in both nominal and real terms across a range of maturities. As a consequence of these developments, low, stable and predictable inflation has encouraged more solid economic growth and lower and less-variable unemployment. The global economic and financial crisis of 2008–09 delivered the largest shock in decades, putting the regime to an unprecedented test. It passed. The experience re-affirmed the strength of Canada’s monetary policy framework, including the value of the regime’s inherent flexibility. Nonetheless, the Bank has sought to draw the appropriate lessons from the debacle, particularly from the experiences of others for whom price stability proved insufficient to prevent economic and financial disaster. Our work has provided important insights into the management of our regime, as well as potential lessons for other countries where trying circumstances have raised questions regarding their monetary policy frameworks. What is the optimal level of inflation? There is an ongoing debate regarding the “right number” for the inflation target. We have been targeting 2 per cent total CPI inflation, in recognition of the benefits of a slightly positive inflation rate in facilitating economic adjustments, and of the potential operational challenges associated with a lower target rate.1 The lower the inflation target, the more likely it is that some nominal wages will occasionally need to decline to facilitate economic adjustment. If workers are reluctant to accept these declines, the process of real BIS central bankers’ speeches Targeting an inflation rate lower than 2 per cent is intuitively appealing, since achieving the target still causes the price level to double roughly every 35 years, which may contribute to money illusion and more generally complicate inter-temporal decision-making. A lower inflation target could also further reduce the costly distortions associated with inflation, such as those stemming from difficulties in distinguishing between absolute and relative price changes, the cost of infrequent price and wage adjustments, and the disincentives to hold money. The Bank’s research has generally found that the further benefits from reducing these distortions imply an optimal rate of inflation closer to, or even slightly below, zero. In a perfect world, we would pursue those gains through a lower inflation target. But we do not live in a perfect world. Even the models that we employ to quantify the additional benefits of a lower inflation target – models that aspire to an economist’s utopia – disagree on how material those benefits would be. Moreover, these models have typically abstracted from the very real-world costs and risks associated with very low rates of inflation, the most important of which is the risk associated with the zero lower bound (ZLB) on interest rates. At this level, conventional monetary policy can no longer be used to stimulate the economy – a risk that was brought into stark relief during the recent crisis. The lower the inflation target, the lower the “equilibrium” nominal policy interest rate will be, and thus the greater the likelihood that shocks will push interest rates to the ZLB during “normal” times. Research at the Bank and elsewhere suggests that encounters with the ZLB should be quite rare with a 2 per cent inflation target, but may be more than four times more likely with a 1 per cent target and at least 16 times more likely with a zero per cent target. Indeed, with a target below 2 per cent, it is likely that the ZLB will be encountered through the ordinary course of the business cycle. The costs of hitting the ZLB depend on the effectiveness, reliability and costs of available unconventional policy instruments. While these unconventional tools – conditional commitments, quantitative easing and credit easing – have provided additional stimulus, the magnitudes of the benefits and of the costs associated with their use will only be known over time. These costs could include financial market distortions, difficulties in unwinding large holdings of securities, and in the extreme, potential compromises to the political independence and credibility of the central bank. With these risks now better appreciated, some have suggested that central banks ought to target an inflation rate higher than 2 per cent. There are essentially two arguments. First, a higher inflation target might reduce the frequency and severity of encounters with the ZLB.2 Second, a higher inflation target may be a way out from the burden of excessive debt in those countries struggling with deleveraging.3 To the Bank of Canada, these are siren calls. Moving opportunistically to a higher inflation target would risk de-anchoring inflation expectations and destroying the hard-won gains that have come from the entrenchment of price stability in these economies. This is especially risky if a very sudden and large inflation “surprise” is needed, as might be the case given the relatively short duration of government debt portfolios in many of these countries. Moreover, if inflation is both higher and more uncertain, a higher inflation risk premium might result, prompting an increase in real rates that would exacerbate unfavourable debt dynamics. adjustment in the labour market will be impeded, inhibiting the efficient functioning of the economy. In other words, a positive inflation target “greases the wheels” of the economy. O. Blanchard, G. Dell’Ariccia and P. Mauro, “Rethinking Macroeconomic Policy,” IMF Staff Position Note SPN/10/03, 2010. K. Rogoff, “Inflation Is Now the Lesser Evil,” Project Syndicate, December 2008. BIS central bankers’ speeches Could targeting the price level be superior? So in our view, moving to a higher inflation target would be risky. However, for foreign countries with high levels of indebtedness and that are already at the ZLB, there might be other mechanisms to achieve higher nominal price paths, while maintaining long-term inflation expectations. The Bank’s research suggests that targeting a path for the level of prices might work. In contrast to an inflation-targeting regime where bygones are bygones, under price-level targeting (PLT), monetary policy would seek to make up for past deviations in order to restore the price level to a predetermined path. For example, following a period of belowtarget inflation, policy would seek a period of above-target inflation in order to ensure that average inflation corresponds to targeted inflation (the desired rate of change in the price level) over time. The more the price level were to undershoot the target, the more the central bank would need to stimulate the economy to make up the undershoot, and the more inflation expectations would thus be expected to rise and real interest rates to fall, supporting spending and prices. This “automatic” provision of added stimulus could be particularly useful when conventional monetary policy is exhausted at the ZLB, while the rise in near-term inflation expectations would be self-limiting by design, unwinding as the price level approached the desired path. PLT may merit consideration as a temporary unconventional policy tool in countries faced with extraordinary circumstances, notably those with policy at the ZLB and with a heavy burden of debt.4 However, it is not clear that it would help much under the current circumstances faced by the crisis economies. This is because the trend in the price level in these countries since the onset of the global crisis has not, in fact, been all that weak.5 So while PLT may help combat future disinflationary pressures in these countries, it is unlikely to be effective in providing additional stimulus now. Accordingly, some have proposed a related framework that could better harness the power of expectations in getting these economies back on track right now – nominal GDP level targeting. In this case, the central bank would seek to make up for the undershoot in the trend in the value of national output.6 That undershoot has been dramatic, reaching 10 per cent in the United States and 11 per cent in the United Kingdom – or nearly 2 trillion dollars combined – relative to the level that would have been attained with trend growth.7 Those gaps are set to widen even further ahead, with real growth projected to remain slow and the inflation rate to fall. Committing to restore the level of nominal GDP to its pre-crisis trend could lend the powerful boost to expectations needed to reduce real debt burdens and more generally provide added stimulus to the economy through lower real interest rates. There are, without question, risks to this approach. For PLT or nominal GDP level targeting to be effective, the expectations channel has to work in practice the way it does in theory. This requires that people be forward-looking, fully conversant with the implications of the See C. Evans, “Monetary Policy in a Low-Inflation Environment: Developing a State-Contingent Price-Level Target”, Remarks delivered to the Federal Reserve Bank of Boston's 55th Economic Conference, Boston, Mass: 16 October 2010. In the third quarter, the level of the headline and core PCE price indexes in the United States stood 0.6 per cent and 1.3 per cent respectively below the level that would have been attained with 2 per cent inflation since the onset of the recession in the fourth quarter of 2007. The level of the headline CPI in the United Kingdom in the third quarter stood 5.5 per cent above the level that would have been attained had inflation met the United Kingdom’s 2 per cent target since the onset of the recession in the first quarter of 2008. See J. Hatzius and S. Stehn. “The Case for a Nominal GDP Level Target,” US Economics Analyst, Goldman Sachs Global ECS Research, Issue No: 11/41, 2011, and C. Romer, “Dear Ben: It’s Time for Your Volker Moment,” The New York Times, 29 October 2011. Assuming nominal GDP had grown at a 4½ per cent annual rate in the United States and United Kingdom from the level prevailing just prior to the onset of recession in these countries. BIS central bankers’ speeches regime and trust policy-makers to live up to their commitment. As Bank research has shown, if these conditions do not fully hold, these approaches could in fact prove destabilizing to the economy and damaging to the central bank’s credibility.8 Moreover, there are reasons why central banks have preferred to support employment and output by targeting price stability, rather than more directly through an approach like nominal GDP targeting. Central banks can neither determine the appropriate path for these real variables nor control them over the long run, and pretending they can could have negative consequences for economic stability and central bank credibility. Indeed, one of the major insights over the past three decades of monetary policy practice has been that targeting employment can create an incentive for surprise inflation, which in turn leads to higher unemployment. The best contribution monetary policy can make to sustainable job creation is low, stable and predictable inflation. The Bank found that the potential benefits of adopting PLT are less valuable under ordinary circumstances, relative to the current inflation-targeting regime. But the risks that the regime might not be well understood or fully credible look no less daunting. Accordingly, the Bank could not comfortably endorse the adoption of a PLT regime as Canada’s monetary policy framework. As is the case with unconventional monetary policy tools, however, the experience of others may provide valuable insights for Canada in the future. How to address financial imbalances? The global economic and financial crisis has made it clear that a central bank pursuing price stability without due regard for financial stability risks achieving neither. Even though Canada did not experience a home-grown financial crisis, it is necessary for the Bank to understand better the lessons painfully learned elsewhere. As we have all been reminded at great cost, low, stable and predictable inflation and low variability in activity can breed complacency among financial market participants, as risktaking adapts to the perceived new equilibrium. Indeed, risk appears to be at its greatest when measures of it are at their lowest. The tendency to overreach is particularly marked if there is a perceived certainty about the stability of low interest rates. In short, complacency can lead to extremes and, ultimately, crisis. The first line of defence against a buildup of financial imbalances is responsible behaviour by individuals and institutions. The more people recognize that they will bear the consequences of their actions, the fewer the problems that will arise. Next comes effective “microprudential” regulation and supervision. Canada has a strong track record in this area, and our experience is being reflected in major international reforms of regulatory and supervisory frameworks for banks. This approach is being enhanced by the adoption of a system-wide perspective. The Government of Canada has already made three timely and prudent adjustments to the terms of mortgage finance. Additional measures, such as the counter-cyclical capital buffer and through the cycle margining, are under development. These defences will go a long way to mitigate the risk of financial excesses, but in some cases, monetary policy may still have to take financial stability considerations into account. This is most obviously the case when financial imbalances affect the near-term outlook for output and inflation. Bank research, using ToTEM and other models, suggests that, as the proportion of agents with forwardlooking expectations declines toward 50 per cent, the advantages of PLT over inflation targeting appear to diminish quickly. S. Murchison, “Consumer Price Index Targeting,” Bank of Canada Working Paper (forthcoming). BIS central bankers’ speeches In some exceptional circumstances where imbalances pose an economy-wide threat and/or where the imbalances themselves are being encouraged by a low interest rate environment, monetary policy might itself be the appropriate tool to support financial stability. Monetary policy has a broad influence on financial markets and on the leverage of financial institutions that cannot easily be avoided. This “bluntness” makes monetary policy an inappropriate tool to deal with imbalances that matter only to a specific sector, but a potentially valuable tool in addressing imbalances that may eventually have economy-wide implications. Furthermore, a general understanding that monetary policy will be used to counteract pre-emptively the buildup of such imbalances is likely to enhance the stabilizing impact of this approach. But this last point should not be overstated. The paramount goal of monetary policy in Canada has been, and remains, price stability. The primary tools to deal with financial stability are micro- and macroprudential regulation and supervision. Macroprudential tools are not a substitute for monetary policy in controlling inflation, and monetary policy cannot substitute for proper micro- and macroprudential supervision and regulation in maintaining financial stability. Confirming Canada’s flexible inflation-targeting regime Armed with these insights, the Bank and the Government have renewed the inflationtargeting regime that has served Canada so well over the past two decades. The core elements of the regime remain unchanged. The Bank will continue to conduct monetary policy aimed at keeping inflation, as measured by the total consumer price index (CPI), at 2 per cent, with a control range of 1 to 3 per cent around this target. The inflation target is symmetric, which means that the Bank is equally concerned about inflation rising above or falling below the 2 per cent target. The Bank continues to use core inflation as an operational guide for its monetary policy because it is an effective indicator of the underlying trend in CPI inflation. Core inflation, along with other measures of inflationary pressures, is monitored to help achieve the target for total CPI inflation; it is not a replacement for the latter. A flexible exchange rate is also a core element of Canada’s monetary policy framework. A floating Canadian dollar plays a key role in the transmission of monetary policy and allows the Bank to pursue an independent monetary policy. It also helps to absorb shocks to the economy. The inflation-targeting framework has always been flexible. Typically, the Bank seeks to return inflation to target over a horizon of six to eight quarters. However, over the past twenty years, there has been considerable variation in the horizon, in response to varying circumstances and economic shocks. This flexibility is required because, when taking monetary policy actions to stabilize inflation at target, the Bank must also manage the volatility that these actions may induce in the economy. These trade-offs will differ depending on the nature and persistence of the shocks buffeting the economy. There are limits to this flexibility. The Bank’s scope to exercise it is founded on the credibility built up through its demonstrated success in achieving the inflation target. This reinforces the importance of continuing the Bank’s relentless focus on achieving the 2 per cent inflation target over time. Conclusion Let me conclude with a quick illustration of how we are applying the framework under current circumstances. As recently as July, markets were expecting the near-term withdrawal of monetary policy stimulus in Canada. At that point, the policy interest rate had remained near historic lows for the better part of a year, even after Canada had recovered both all of the jobs and all of the output lost during the recession. This degree of stimulus was in part BIS central bankers’ speeches necessitated by the considerable external headwinds facing the Canadian economy, including weak U.S. activity and the persistent strength of the Canadian dollar. Since then, the Canadian economy has been hit by major shocks. The global economic outlook has weakened considerably and financial market volatility has increased, owing in particular to the ongoing European sovereign debt crisis. European authorities have announced important plans to provide time to refound their monetary union, but acute strains persist. At this point, the crisis appears barely contained. In Canada, total CPI inflation is near the top of the target range, and preliminary evidence suggests that economic growth in the second half of the year will be slightly stronger than the Bank had projected in the October Monetary Policy Report. However, as outlined in the October Report, a weaker external outlook is expected to dampen growth in Canada through financial, confidence and trade channels. Domestic demand is expected to remain the primary driver of growth in Canada, but these shocks from abroad imply more subdued growth in household expenditures and less vigorous growth in business investment. As a result, the Bank continues to expect excess supply in the economy to persist well into 2013. This, along with the reversal of earlier sharp increases in food and energy prices, is expected to push total CPI inflation toward the bottom of the target range by the middle of next year. In this environment, the Bank judges it appropriate to maintain the considerable monetary stimulus in place. This stimulus has been further enhanced by the sharp fall in global riskfree yields, which is providing further support to the Canadian economy through our wellfunctioning financial system. 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. In a perfect world, there would be no further shocks, and those that have hit us would have precisely the effects that we anticipate. Then again, in a perfect world, these shocks wouldn’t have happened in the first place. We make monetary policy in the real world, where shocks are a fact of life. That is why the Bank responds with a flexible approach, taking decisions guided by considered analysis and informed judgment rather than mechanical rules. It is our job to anticipate potential shocks, analyse their impact on economic activity and inflation in Canada, and set monetary policy consistent with achieving the 2 per cent inflation target over time. This ultimately remains the best contribution that monetary policy can make to the economic well-being of Canadians. BIS central bankers’ speeches
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, at the State University of New York at Plattsburgh, Plattsburgh, New York, 29 November 2011.
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John Murray: With a little help from your friends – the virtues of global economic coordination Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, at the State University of New York at Plattsburgh, Plattsburgh, New York, 29 November 2011. * * * “Uneven growth and widening imbalances are fuelling the temptation to diverge from global solutions into uncoordinated actions. However, uncoordinated policy actions will only lead to worse outcomes for all.” G-20 Leaders Declaration, Seoul Summit 11–12 November 2010 “We, the Finance Ministers and Central Bank Governors of the G-20, affirm our commitment to take all necessary initiatives in a coordinated way to support financial stability and to foster stronger economic growth in the spirit of cooperation and confidence.” Statement of G-20 Finance Ministers and Central Bank Governors 8 August 2011 Introduction Thank you very much for the invitation to deliver the Distinguished Canadian Address on a contemporary public policy issue. I am honoured to be here and grateful for the opportunity to speak to you about one of the most important public policy issues that we are confronting in these extraordinarily difficult times. Policy-makers around the world are facing two critical challenges of a truly systemic nature: restoring stability in Europe and rebuilding strong, sustainable and balanced growth in the global economy. The two quotes above are testament to the firm and shared belief of today’s policy-makers that these challenges can be met only through timely and comprehensive policy coordination across countries. Yet a generation ago, both academics and policymakers shared the equally firm belief that the prospective gains from global coordination were minimal, if not negative. They advocated a more independent approach to policy formulation and implementation, and advised authorities to simply “keep their own houses in order” and leave the rest to the insulating properties of flexible exchange rates. This quote from Stanley Fischer is representative of the consensus view that prevailed in the late 1980s: “[M]ore consistent ongoing policy coordination in which countries, including the United States, significantly modify national policies “in recognition of international policy interdependence” is not on the near horizon. Fortunately, the evidence suggests that the potential gains from coordination are in any event small: the best that each country can do for other countries is to keep its own economy in shape.”1 My remarks today are divided into three parts. First, I will outline the assumptions and research that supported the earlier, independent view of policy making. Second, I will trace S. Fischer, “International Macroeconomic Policy Coordination,” International Economic Cooperation, edited by Martin Feldstein, NBER, (Chicago, University of Chicago Press, 1988) 11–43. BIS central bankers’ speeches the evolution of thought since that time, and track the principal drivers behind the apparent change in attitude. Finally, I will present an example, drawn from the Bank of Canada’s own modelling work, that highlights the prospective benefits of more effective policy coordination in the context of the current challenges. Prevailing view in the 1970s and 1980s Most academic economists and policy-makers in the period immediately following the collapse of Bretton Woods readily acknowledged the potential benefits of co-operative behaviour, but viewed these gains as small in practice. In a world characterized by growing economic interdependence and cross-border spillovers, it stood to reason that something could be gained by operating in a more coordinated manner. Such actions, they believed, would minimize negative externalities and lead to Pareto-improving outcomes in which all parties would benefit and the losses inherent in non-co-operative Nash outcomes could be avoided. As a practical matter, however, these gains were believed to be very modest and perhaps even negative. One of the principal reasons for this was a strong belief in the insulating effects of flexible exchange rates, which would not only give authorities the ability to conduct effective, independent monetary policies but would serve as an automatic buffer from both external and internal shocks. A second reason for this independent approach to policy-making was the limited degree of economic interdependence that existed at the time. Although trade flows had been liberalized in successive GATT rounds through the 1960s, 1970s and 1980s, they remained a small, albeit rapidly growing, component of the GDPs of most countries. Moreover, this was the only metric by which interdependence was typically judged. International capital flows were still severely restricted in Europe and Japan, and financial linkages were still at a relatively vestigial stage – the Herstatt Bank incident notwithstanding.2 Persuasive theoretical and empirical arguments against coordination were also brought to bear during this period. Rogoff (1985) wrote an influential paper showing how greater co-operation among monetary authorities might lead to an undesirable equilibrium, characterized by increased instability and higher global inflation.3 He argued that without the discipline provided by individual decision-making in a competitive setting and the risk of a sharply depreciating exchange rate in response to any suspected policy misbehaviour, authorities would feel free to collectively ease interest rates in the hopes of securing some short-term gain in output and employment. Frankel and Rockett (1988) joined the debate and underscored the problems that might arise if policy-makers decided to coordinate using the wrong macro model of the economy.4 The authors conducted a “horse race” with 11 of the most popular models of the time, and found dramatically different results depending on which model was chosen. Since only one of them could be right – but which one remained uncertain – putting all your policy eggs in a single basket was probably unwise. They showed that better results might be obtained through time Bankhaus Herstatt was a mid-sized German bank that was active in foreign exchange markets and 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 “lessconnected” 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. K. Rogoff, “Can International Monetary Policy Cooperation be Counterproductive?” Journal of International Economics 18 (1985): 199–217. J. Frankel and K. E. Rockett, “International Macroeconomic Policy Coordination when Policymakers Do not agree on the True Model,” American Economic Review 78, no.3(1988): 318–340. BIS central bankers’ speeches by allowing policy-makers to choose their favourite model rather than forcing everyone to coordinate around a single model. Oudiz and Sachs (1984) reinforced the case against coordination by simulating their state-of-the-art general equilibrium model and showing that, even if one picked the right model, the improvement, relative to proceeding independently, was very modest.5 It is important to note that all of these cautions came from the economics side. If one factored in the risk of political misdirection and the scope for the inept application of policy, the chances of success seemed even more remote. Doug Purvis, a well-known Canadian macroeconomist, referred to G-7 policy coordination as fine-tuning to the seventh power. Certainly, real-world evidence did not seem to offer great hope. Mixed success at attempted coordination through the 1970s and 1980s, and the collapse of the Bretton Woods system itself – the most ambitious effort at international policy coordination – all appeared to point in the same direction. So what changed? Looking at the more recent policy statements from the G-20 leaders one can’t help but be struck by the sea change that has occurred in received wisdom. Has the world changed, or were earlier views simply wrong? It is probably a little of both. First and foremost, international linkages have risen dramatically over the past 20 years, increasing the significance of spillovers. This is clear in the trade numbers, which have typically increased at twice the rate of global GDP, but is even more evident in the escalating volume of gross financial flows (Charts 1 and 2). Recent evidence suggests that their effects can far outweigh those of trade flows. Second, flexible exchange rates, which have a great deal to recommend them, have failed to live up to their initial optimistic billing. (Canada’s positive experience with a flexible exchange rate through the 1950s and early 1960s might have contributed to this overly sanguine assessment.) Their stabilizing properties were shown to be more limited than previous enthusiasts had credited. Adding to these complications is the limited scope that now exists for significant adjustment in policy-makers’ standard fiscal and monetary instruments. The zero lower bound on interest rates and the elevated levels of government debt and deficits in most of the major advanced economies have left very little room for manoeuvre (Charts 3 and 4). It is important to note that the earlier view had more of an ex ante orientation. “Tending to your knitting” or “keeping your own house in order” (with apologies for the mixed metaphors) was seen as a way of avoiding trouble for oneself and others. The fact that this prescription was not followed by everyone is, no doubt, one of the contributing factors in the present dilemma, if not the primary cause. Second-best strategies for staying out of trouble, such as keeping your own house in order, may now have to give way to third-best coordination strategies, ex post, if one is trying to escape from a difficult situation with limited room for manoeuvre on the policy front. A little help from your friends might be all you have left. In fairness to the proponents of the earlier independent approach, while they were skeptical of formal policy coordination, they typically assumed that a light-handed but important form of “soft” policy co-operation would nevertheless exist. More specifically, policy-makers were assumed to meet regularly – as they in fact do – in order to exchange views on the state of G. Oudiz and J. Sachs, “Macroeconomic Policy Coordination among the Industrial Economies,” Brookings Papers on Economic Activity 1 (1984): 1–65. BIS central bankers’ speeches the global economy and get a sense of what they might do in alternative states of the world – if not fully revealing their near-term game plan. Proponents of the “less is more” view also expected countries to play by the rules of the game as implicitly understood at the time. Most importantly, advanced economies, which dominated the global scene by a wide margin during this period, were assumed to operate under a fully flexible exchange rate system. Even if some countries might choose to fix their currencies, this would not necessarily pose a problem. Unlike many of the present-day emerging market economies (EMEs), they were not expected to engage in persistent sterilized interventions in an effort to subvert the price adjustment process. Challenges facing policy-makers today As noted earlier, the two most pressing challenges facing policy-makers today are: • finding a solution to the European debt crisis; and • putting the global economy on a path to strong, sustainable growth. The first of these is in some sense logically prior to the second. However, providing a credible prospect of long-term growth is also necessary for achieving the first objective. Fiscal and banking problems are not going to be solved by deleveraging alone. It will also be necessary to expand the size of the global pie in a more evenly distributed manner if long-run stability is to be achieved. The remainder of my presentation will focus on the G-20 Framework for Strong, Sustainable and Balanced Growth. The world economy, in aggregate, is suffering from deficient demand (i.e., a deflationary gap). Beneath these aggregate numbers, however, is an obvious imbalance. Some countries, mostly EMEs, have been growing too quickly, leading to inflationary pressures and other serious market distortions. Others, mainly – but not exclusively – advanced countries, suffer from too little growth. Given these starting positions, there should be a way of making both groups better off by rotating demand from one to the other. Unfortunately, this has been much more difficult to achieve in practice than it would appear. The uneven pattern of growth that we are presently experiencing is matched by unsustainable external imbalances, with many advanced countries running sizable current account deficits, despite their slow growth, while many EMEs are running sizable surpluses, despite their strong growth (Chart 5). In many cases, of course, the export-led development strategies that some EMEs pursue, and the resulting trade surpluses, are the reason for their phenomenal growth. While exchange rate misalignment is an important external driver of the trade imbalances, a number of internal imbalances have also contributed to the problem, such as runaway government and household debt, and will have to be addressed before a sustainable solution can be achieved. Major advanced economies with deficient demand cannot consolidate their fiscal positions and boost household savings without support from the external side in the form of increased foreign demand. Meanwhile, EMEs, seeing their growth decelerate because of sagging demand in advanced countries, are reluctant to abandon a strategy that has served them so well in the past, and have refused to let their exchange rates adjust in a material way. Sterilized intervention continued at an accelerating pace over most of the past four years, and new “macroprudential stabilization tools” (i.e., capital controls) have been introduced to further buttress their defences. Advanced countries, receiving limited assistance from some of their most important EME trading partners, have been forced either to use what little fiscal space remains to stimulate their economies or to resort increasingly to unconventional monetary policy remedies, such as the Fed’s quantitative easing. The latter, in turn, tend to push capital flows toward EMEs in ever-larger amounts, exacerbating EME concerns about BIS central bankers’ speeches the twin Hecubas of sudden stops and destabilizing credit growth, causing them to tighten their controls further (Chart 6). The vicious circle that is thereby created, as each waits for the other to do the right thing, threatens to destabilize the entire global economy. How can we escape this “prisoner’s dilemma”? The G-20 Framework for Strong, Sustainable and Balanced Growth offers just such an escape. It has four key components: • fiscal consolidation in those countries that need it; • a rotation of global demand (facilitated by greater exchange rate flexibility); • sweeping financial sector reforms; and • ambitious structural reforms to the real economy to foster higher long-run growth. I will not have much to say about financial sector reform, except to note that it is probably proceeding at a faster pace than the other three components, despite the breadth of the reform agenda. While much has already been agreed upon, actions mean more than words and implementation is obviously critical. Structural reform, in contrast, is moving exceptionally slowly, with few specific and concrete reforms being proposed by any of the G-20 countries. While it is difficult to garner the sort of political support necessary to drive significant change in the midst of a crisis, the reverse is also true. The momentum for reform seems to disappear once things appear to be getting better. Countries must break out of this paralyzing pattern and, instead, seize the opportunity to do the right thing now. Fiscal consolidation is proceeding more rapidly, in some cases, than short-term macroeconomic conditions might warrant. However, countries are being forced to accelerate the pace of tightening by increasingly skeptical and impatient market “vigilantes,” lest they fall into the ranks of those already deemed too far gone to save. Ideally, countries would be able to outline a credible longer-term plan for fiscal sustainability, and receive in return increased room for manoeuvre (i.e., easing, or less tightening) in the short term. This Augustinian approach to fiscal probity is clearly difficult, if not impossible, to effect in practice. As a result, many countries are finding themselves with less room for manoeuvre than they expected. Regrettably, it is movement on the exchange rate front and the correction of external imbalances that are proceeding at the most glacial pace (Chart 7). A way must be found to break this log-jam to everyone’s advantage. The Mutual Assessment Process (MAP) that the G-20 has initiated and the use of indicative guidelines are expected to help push the process forward, but meaningful action, as opposed to agreement on the mechanics of the MAP, appears to be lacking. Model simulations The final section of my presentation contains some model results highlighting how much could be gained globally from timely and simultaneous action on many of these fronts – and by the converse – how much could be lost if it is done poorly or not done at all. I’d like to stress at the outset that these simulations are not merely illustrative. They are based on an estimated global model that the Bank of Canada uses internally for its forecast exercises and analysis of alternative policy scenarios. By the same token, I won’t try to suggest that the model does more than it can, despite being the best of breed. A healthy degree of caution has to be applied to all such exercises. Still, I think you’ll find the results interesting. We begin with a base case and use our model to identify a set of conditions that are sufficient for the resolution of global imbalances. These include: • increasing U.S. private savings rates and maintaining them through time at 6 per cent of GDP; BIS central bankers’ speeches • engineering a gradual, timely and credible fiscal consolidation in the United States, Europe and Japan; • allowing the real effective exchange rate for China to appreciate by 20 per cent, while the U.S. dollar depreciates by 15 per cent; • implementing policies to stimulate domestic demand in China and emerging Asia; and • pursuing a program of gradual but meaningful structural reform in Europe and Japan to raise potential growth. This should not be interpreted as a Goldilocks scenario. It might be possible to do much better with more ambitious and concerted action; however, it is sufficient to stabilize government debt and deficits, together with current account balances, at sustainable levels. We might call it a “good,” as opposed to “great,” outcome. In an alternative scenario, we ask what would happen if the implementation of these corrective measures were delayed by five years (i.e., over our projection horizon), after which time they are allowed to kick in. In other words, this alternative scenario eventually course corrects and is by no means as bad as it can be. The results for the good and (somewhat) bad scenarios are shown in the graph below. Postponing the required policy measures in emerging Asia, including China, and in the advanced countries produces a cumulative 8 per cent decline in world and U.S. GDP relative to the baseline, while the difference in China’s GDP is roughly 12 per cent. In 2017, world GDP is lower by over US$7 trillion, and it could well be much worse (Chart 8). A third, and separate, scenario that we conducted on an earlier occasion is in many ways even more interesting. It asks what would happen if fiscal consolidation and household balance-sheet repair were actively pursued in the advanced countries – whether voluntarily or driven by impatient financial markets – but without the support of rising external demand in those countries that needed it (i.e., absent exchange rate adjustment and stimulative policies in emerging Asia). The resulting loss in global GDP is greater than under the bad solution, at least over the fiveyear horizon. Doing half the job, in other words, is worse over the short- to medium run than doing nothing. Fiscal consolidation and the repair of household balance sheets are necessary and inevitable, but doing them quickly, unassisted by growth from elsewhere, deepens global deflation. EMEs will not be able to decouple in these scenarios. Although many of them face inflationary pressures at the moment, and serious distortions to their domestic economies, they will be quickly caught up in a vortex of imploding demand from the advanced economies and follow them down. Rotating global demand through the timely adjustment of exchange rates and structural reform could prevent this. Sounds good. Everybody wins. So why hasn’t it happened? Fear, narrow self-interest and political inertia are the reasons. This is why adopting an “After you, Alphonse strategy" is bound to fail. The hope is that, by everyone agreeing to move together, these impediments can be overcome. Everyone should hold hands and take a leap of faith – but not blind faith, mind you. There is good reason to think it will work. It certainly looks better than the alternatives. Thank you for your attention. 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Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Empire Club of Canada/Canadian Club of Toronto, Toronto, Ontario, 12 December 2011.
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Mark Carney: Growth in the age of deleveraging Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Empire Club of Canada/Canadian Club of Toronto, Toronto, Ontario, 12 December 2011. * * * Introduction These are trying times. In our largest trading partner, households are undergoing a long process of balance-sheet repair. Partly as a consequence, American demand for Canadian exports is $30 billion lower than normal. In Europe, a renewed crisis is underway. An increasing number of countries are being forced to pay unsustainable rates on their borrowings. With a vicious deleveraging process taking hold in its banking sector, the euro area is sinking into recession. Given ties of trade, finance and confidence, the rest of the world is beginning to feel the effects. Most fundamentally, current events mark a rupture. Advanced economies have steadily increased leverage for decades. That era is now decisively over. The direction may be clear, but the magnitude and abruptness of the process are not. It could be long and orderly or it could be sharp and chaotic. How we manage it will do much to determine our relative prosperity. This is my subject today: how Canada can grow in this environment of global deleveraging. How we got here: the debt super cycle First, it is important to get a sense of the scale of the challenge. Accumulating the mountain of debt now weighing on advanced economies has been the work of a generation. Across G-7 countries, total non-financial debt has doubled since 1980 to 300 per cent of GDP. Global public debt to global GDP is almost at 80 per cent, equivalent to levels that have historically been associated with widespread sovereign defaults.1 The debt super cycle has manifested itself in different ways in different countries. In Japan and Italy, for example, increases in government borrowing have led the way. In the United States and United Kingdom, increases in household debt have been more significant, at least until recently. For the most part, increases in non-financial corporate debt have been modest to negative over the past thirty years. In general, the more that households and governments drive leverage, the less the productive capacity of the economy expands, and, the less sustainable the overall debt burden ultimately is. Another general lesson is that excessive private debts usually end up in the public sector one way or another. Private defaults often mean public rescues of banking sectors; recessions fed by deleveraging usually prompt expansionary fiscal policies. This means that the public C. M. Reinhart and K. S. Rogoff, “A Decade of Debt,” National Bureau of Economic Research Working Paper No. 16827, Cambridge, 2011. BIS central bankers’ speeches debt of most advanced economies can be expected to rise above the 90 per cent threshold historically associated with slower economic growth.2 The cases of Europe and the United States are instructive. Today, American aggregate non-financial debt is at levels similar to those last seen in the midst of the Great Depression. At 250 per cent of GDP, that debt burden is equivalent to almost US$120,000 for every American (Chart 1).3 Several factors drove a massive increase in American household leverage. Demographics have played a role, with the shape of the debt cycle tracking the progression of baby boomers through the workforce. The stagnation of middle-class real wages (itself the product of technology and globalisation) meant households had to borrow if they wanted to maintain consumption growth.4 Financial innovation made it easier to do so. And the ready supply of foreign capital from the global savings glut made it cheaper. Most importantly, complacency among individuals and institutions, fed by a long period of macroeconomic stability and rising asset prices, made this remorseless borrowing seem sensible. From an aggregate perspective, the euro area’s debt metrics do not look as daunting. Its aggregate public debt burden is lower than that of the United States and Japan. The euro area’s current account with the rest of the world is roughly balanced, as it has been for some time. But these aggregate measures mask large internal imbalances. As so often with debt, distribution matters (Chart 2). C. M. Reinhart and K. S. Rogoff, “Growth in a Time of Debt,” American Economic Review 100, no. 2 (May 2010): 573–78. These figures, daunting as they are, actually understate the extent of the problem. They do not include the liabilities stemming from the pension and health care promises made by governments but not yet funded, which some estimate to be even larger than the current explicit stock of debt. R. G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton: Princeton University Press, 2010). BIS central bankers’ speeches Europe’s problems are partly a product of the initial success of the single currency. After its launch, cross-border lending exploded. Easy money fed booms, which flattered government fiscal positions and supported bank balance sheets. Over time, competitiveness eroded. Euro-wide price stability masked large differences in national inflation rates. Unit labour costs in peripheral countries shot up relative to the core economies, particularly Germany. The resulting deterioration in competitiveness has made the continuation of past trends unsustainable (Chart 3). Growth models across Europe must radically change. It’s the balance of payments, stupid! For years, central bankers have talked of surplus and deficit countries, of creditors and debtors. We were usually ignored. Indeed, during a boom, the debtor economy usually feels more vibrant and robust than its creditors. In an era of freely flowing capital, some even BIS central bankers’ speeches thought current account deficits did not matter, particularly if they were the product of private choices rather than public profligacy. When the leverage cycle turns, the meaning and implications of these labels become tangible. Creditors examine more closely how their loans were spent. Foreign financing constraints suddenly bind. And to repay, debtors must quickly restore competitiveness.5 Financial globalisation has provided even greater scope for external imbalances to build (Chart 4). And its continuation could permit larger debt burdens to persist for longer than historically was the case. However, experience teaches that sustained large cross-border flows usually presage liquidity crunches.6 The global Minsky moment has arrived Debt tolerance has decisively turned. The initially well-founded optimism that launched the decades-long credit boom has given way to a belated pessimism that seeks to reverse it. Excesses of leverage are dangerous, in part because debt is a particularly inflexible form of financing. Unlike equity, it is unforgiving of miscalculations or shocks. It must be repaid on time and in full. While debt can fuel asset bubbles, it endures long after they have popped. It has to be rolled over, although markets are not always there. It can be spun into webs within the financial sector, to be unravelled during panics by their thinnest threads. In short, the central relationship between debt and financial stability means that too much of the former can result abruptly in too little of the latter. Japan illustrates the importance of whether one’s creditors are domestic or foreign. The public and total nonfinancial debt burdens in Japan have risen well beyond levels that have proved unsustainable in other countries, owing largely to the fact that the preponderance of that debt is owed domestically. From an external perspective, Japan is the largest net creditor in the world. See M. Carney, “Global Liquidity,” a speech delivered to the Canada-United Kingdom Chamber of Commerce in London, United Kingdom, 8 November 2011. BIS central bankers’ speeches Hard experience has made it clear that financial markets are inherently subject to cycles of boom and bust and cannot always be relied upon to get debt levels right.7 This is part of the rationale for micro- and macroprudential regulation. It follows that backsliding on financial reform is not a solution to current problems. The challenge for the crisis economies is the paucity of credit demand rather than the scarcity of its supply. Relaxing prudential regulations would run the risk of maintaining dangerously high leverage – the situation that got us into this mess in the first place. The implications of deleveraging As a result of deleveraging, the global economy risks entering a prolonged period of deficient demand. If mishandled, it could lead to debt deflation and disorderly defaults, potentially triggering large transfers of wealth and social unrest. History suggests that recessions involving financial crises tend to be deeper and have recoveries that take twice as long.8 The current U.S. recovery is proving no exception (Chart 5). Indeed, it is only with justified comparisons to the Great Depression that the success of the U.S. policy response is apparent. Such counterfactuals – it could have been worse – are of cold comfort to American households. Their net worth has fallen from 6 ½ times income pre-crisis to about 5 at present (Chart 6). These losses can only be recovered through a combination of increased savings and, eventually, rising prices for houses and financial assets. Each will clearly take time. In Europe, a tough combination of necessary fiscal austerity and structural adjustment will mean falling wages, high unemployment and tight credit conditions for firms. Europe is See A. Turner, “Debt and Deleveraging: Long Term and Short Term Challenges,” a speech delivered to the Centre for Financial Studies, Frankfurt, Germany, 21 November 2011. Turner argues, in fact, that the current situation is the result of “decades of cumulative, massive policy errors,” particularly the over reliance on free markets, (p. 6). 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 unlikely to return to its pre-crisis level of GDP until a full five years after the start of its last recession (Chart 7). Managing the deleveraging process Austerity is a necessary condition for rebalancing, but it is seldom sufficient. There are really only three options to reduce debt: restructuring, inflation and growth. Whether we like it or not, debt restructuring may happen. If it is to be done, it is best done quickly. Policy-makers need to be careful about delaying the inevitable and merely funding the private exit. Historically, as an alternative to restructuring, financial repression has been used to achieve negative real interest rates and gradual sovereign deleveraging. BIS central bankers’ speeches Some have suggested that higher inflation may be a way out from the burden of excessive debt.9 This is a siren call. Moving opportunistically to a higher inflation target would risk unmooring inflation expectations and destroying the hard-won gains of price stability. Similarly, strategies such as nominal GDP level targeting would fail unless they are well understood by the public and the central bank is highly credible.10, 11 With no easy way out, the basic challenge for central banks is to maintain price stability in order to help sustain nominal aggregate demand during the period of real adjustment. In the Bank’s view, that is best accomplished through a flexible inflation-targeting framework, applied symmetrically, to guard against both higher inflation and the possibility of deflation. The most palatable strategy to reduce debt is to increase growth. In today’s reality, the hurdles are significant. Once leverage is high in one sector or region, it is very hard to reduce it without at least temporarily increasing it elsewhere. In recent years, large fiscal expansions in the crisis economies have helped to sustain aggregate demand in the face of private deleveraging (Chart 8). However, the window for such Augustinian policy is rapidly closing. Few except the United States, by dint of its reserve currency status, can maintain it for much longer. In most of Europe today, further stimulus is no longer an option, with the bond markets demanding the contrary. K. Rogoff, “Inflation Is Now the Lesser Evil,” Project Syndicate, December 2008. See J. Hatzius, Z. Pandl, A. Phillips, and S. J. Stehn, A. Tilton, S. Wu, and M. Acosta-Cruz, “The Case for a Nominal GDP Level Target,” US Economics Analyst, No: 11/41; Goldman Sachs Global ECS Research, 2011; and C. Romer, “Dear Ben: It’s Time for Your Volcker Moment,” New York Times, 29 October 2011. Indeed, if inflation is both higher and more uncertain, a higher inflation risk premium might result, prompting an increase in real interest rates that would exacerbate unfavourable debt dynamics. BIS central bankers’ speeches There are no effective mechanisms that can produce the needed adjustment in the short term. Devaluation is impossible within the single-currency area; fiscal transfers and labour mobility are currently insufficient; and structural reforms will take time. Actions by central banks, the International Monetary Fund and the European Financial Stability Facility can only create time for adjustment. They are not substitutes for it. To repay the creditors in the core, the debtors of the periphery must regain competitiveness. This will not be easy. Most members of the euro area cannot depreciate against their major trading partners since they are also part of the euro. Large shifts in relative inflation rates between debtor and creditor countries could result in real exchange rate depreciations between euro-area countries. However, it is not clear that ongoing deflation in the periphery and higher inflation in the core would prove any more tolerable than it did between the United Kingdom and the United States under the postwar gold standard of the 1920s and 1930s. The route to restoring competitiveness is through fiscal and structural reforms. These real adjustments are the responsibility of citizens, firms and governments within the affected countries, not central banks. A sustained process of relative wage adjustment will be necessary, implying large declines in living standards for a period in up to one-third of the euro area. We welcome the measures announced last week by European authorities, which go some way to addressing these issues. With deleveraging economies under pressure, global growth will require global rebalancing. Creditor nations, mainly emerging markets that have benefited from the debt-fuelled demand boom in advanced economies, must now pick up the baton. This will be hard to accomplish without co-operation. Major advanced economies with deficient demand cannot consolidate their fiscal positions and boost household savings without support from increased foreign demand. Meanwhile, emerging markets, seeing their growth decelerate because of sagging demand in advanced countries, are reluctant to abandon a strategy that has served them so well in the past, and are refusing to let their exchange rates materially adjust. Both sides are doubling down on losing strategies. As the Bank has outlined before, relative to a co-operative solution embodied in the G-20’s Action Plan, the foregone output could be enormous: lower world GDP by more than US$7 trillion within five years (Chart 9). Canada has a big stake in avoiding this outcome. BIS central bankers’ speeches To summarize thus far The market cannot be solely relied upon to discipline leverage. It is not just the stock of debt that matters, but rather, who holds it. Heavy reliance on crossborder flows, particularly when they fund consumption, usually proves unsustainable. As a consequence of these errors, advanced economies are entering a prolonged period of deleveraging. Central bank policy should be guided by a symmetric commitment to the inflation target. Central banks can only bridge real adjustments; they can’t make the adjustments themselves. Rebalancing global growth is the best option to smooth deleveraging, but its prospects seem distant. What it means for Canada Canada has distinguished itself through the debt super cycle (Chart 10), though there are some recent trends that bear watching. Over the past twenty years, our non-financial debt increased less than any other G-7 country. In particular, government indebtedness fell sharply, and corporate leverage is currently at a record low (Chart 11). BIS central bankers’ speeches In the run-up to the crisis, Canada’s historically large reliance on foreign financing was also reduced to such an extent that our net external indebtedness was virtually eliminated. Over the same period, Canadian households increased their borrowing significantly. Canadians have now collectively run a net financial deficit for more than a decade, in effect, demanding funds from the rest of the economy, rather than providing them, as had been the case since the Leafs last won the Cup. Developments since 2008 have reduced our margin of manoeuvre. In an environment of low interest rates and a well functioning financial system, household debt has risen by another 13 percentage points, relative to income. Canadians are now more indebted than the Americans or the British. Our current account has also returned to deficit, meaning that foreign debt has begun to creep back up. The funding for these current account deficits has been coming largely from foreign purchases of Canadian portfolio securities, particularly bonds. Moreover, much of the proceeds of these capital inflows seem to be largely, on net, going to fund Canadian household expenditures, rather than to build productive capacity in the real economy. If we can take one lesson from the crisis, it is the reminder that channelling cheap and easy capital into unsustainable increases in consumption is at best unwise. Canada’s relative virtue throughout the debt super cycle affords us a privileged position now that the cycle has turned. Unlike many others, we still have a risk-free rate and a wellfunctioning financial system to support our economy. It is imperative that we maintain these advantages. Fortunately, this means largely doing what we have been doing – individuals and institutions acting responsibly and policy-makers executing against sound fiscal, monetary and regulatory frameworks. It cannot entirely be business as usual. Our strong position gives us a window of opportunity to make the adjustments needed to continue to prosper in a deleveraging world. But opportunities are only valuable if seized. First and foremost, that means reducing our economy’s reliance on debt-fuelled household expenditures. To this end, 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. Banks are also raising capital to comply with new regulations. Canadian authorities are co-operating closely and will continue to monitor the financial situation of the household sector. To eliminate the household sector’s net financial deficit would leave a noticeable gap in the economy. Canadian households would need to reduce their net financing needs by about $37 billion per year, in aggregate. To compensate for such a reduction over two years could require an additional 3 percentage points of export growth, 4 percentage points of government spending growth or 7 percentage points of business investment growth. Any of these, in isolation, would be a tall order. Export markets will remain challenging. Government cannot be expected to fill the gap on a sustained basis. But Canadian companies, with their balance sheets in historically rude health, have the means to act – and the incentives. Canadian firms should recognize four realities: they are not as productive as they could be; they are under-exposed to fast-growing emerging markets; those in the commodity sector can expect relatively elevated prices for some time; and they can all benefit from one of the most resilient financial systems in the world. In a world where deleveraging holds back demand in our traditional foreign markets, the imperative is for Canadian companies to invest in improving their productivity and to access fast-growing emerging markets. This would be good for Canadian companies and good for Canada. Indeed, it is the only sustainable option available. A virtuous circle of increased investment and increased BIS central bankers’ speeches productivity would increase the debt-carrying capacity of all, through higher wages, greater profits and higher government revenues. This should be our common focus. The Bank of Canada is doing its part by fulfilling its mandate to keep inflation low, stable and predictable so that Canadian households and firms can invest and plan for the future with confidence. It is also assisting the federal government in ensuring that Canada’s worldleading financial system will be there for Canadians in bad times as well as good and in pushing the G-20 Action Plan because it is in Canada’s interests. Conclusion It makes sense to step back and consider current challenges through the longer arc of financial history. Today’s venue is an appropriate place to do so. A century ago, when the Empire Club and the Canadian Club of Toronto would meet, the first great leveraging of the Canadian economy was well under way. During the three decades before the First World War, Canada ran current account deficits averaging 7 per cent of GDP. These deficits were largely for investment and were principally financed by long-term debt and foreign direct investment. On the eve of the Great War, our net foreign liabilities reached 140 per cent of GDP, but our productive capacity built over the decades helped to pay them off over time. Our obligations would again swell in the Great Depression. But in the ensuing boom, we were again able to shrink our net liabilities. When we found ourselves in fiscal trouble in the 1990s, Canadians made tough decisions, so that on the eve of Lehman’s demise, Canada was in the best fiscal shape in the G-7. We must be careful, however, not to take too much comfort from these experiences. Past is not always prologue. In the past, demographics and productivity trends were more favourable than they are today. In the past, we deleveraged during times of strong global growth. In the past, our exchange rate acted as a valuable shock absorber, helping to smooth the rebuilding of competitiveness that can only sustainably be attained through productivity growth. Today, our demographics have turned, our productivity growth has slowed and the world is undergoing a competitive deleveraging. We might appear to prosper for a while by consuming beyond our means. Markets may let us do so for longer than we should. But if we yield to this temptation, eventually we, too, will face painful adjustments. It is better to rebalance now from a position of strength; to build the competitiveness and prosperity worthy of our nation. 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, 18 January 2012.
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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, 18 January 2012. * * * 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 outlook for the global economy has deteriorated and uncertainty has increased since the Bank released its October MPR. The sovereign debt crisis in Europe has intensified, conditions in international financial markets have tightened, and risk aversion has risen. The recession in Europe is now expected to be deeper and longer than previously anticipated. The Bank continues to assume that European authorities will implement sufficient measures to contain the crisis, although this assumption is clearly subject to downside risks. In the United States, the rebound in real GDP during the second half of 2011 was stronger than anticipated. However, the Bank expects the recovery will proceed at a more modest pace going forward, owing to ongoing household deleveraging, fiscal consolidation and the spillovers from Europe. Chinese growth is decelerating, as expected, toward a more sustainable pace. Prices for most commodities are expected to remain relatively elevated, although at levels below those anticipated in October. The Bank’s overall outlook for the Canadian economy is little changed from October. While there was more momentum than anticipated in the second half of 2011, the pace of growth going forward is expected to be more modest than previously envisaged, largely due to the external environment. Household spending is now projected to grow at a steady pace through 2013. Reflecting an upwardly-revised profile for residential investment, household expenditures are now expected to remain high relative to GDP over the projection horizon and the ratio of household debt to income is projected to rise further. While dampened somewhat by the external environment, business investment is expected to grow at a solid pace. Net exports are expected to contribute little to growth, reflecting moderate foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. The Bank estimates that the Canadian economy grew by 2.4 per cent in 2011 and projects that it will grow by 2.0 per cent in 2012 and 2.8 per cent in 2013. While the economy appears to be operating with less slack than previously assumed, given the more modest growth profile, it is only anticipated to return to full capacity by the third quarter of 2013. The dynamics for inflation are similar to those anticipated in October, although its profile is marginally firmer. Both total and core inflation are expected to moderate in 2012 before reaching 2 per cent by the third quarter of 2013, as excess supply is slowly absorbed, labour compensation grows modestly and inflation expectations remain well-anchored. Several significant upside and downside risks are present in the inflation outlook for Canada. BIS central bankers’ speeches The three main upside risks to inflation in Canada relate to the possibility of stronger-than-expected inflationary pressures in the global economy, stronger-thanexpected growth in the U.S. economy and stronger momentum in Canadian household spending. The two main downside risks to inflation in Canada relate to sovereign debt and banking concerns in Europe and the possibility that growth in household spending could be weaker than projected. Overall, the Bank judges that these risks 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. 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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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the Rotman Institute for International Business, Toronto, Ontario, 7 February 2012.
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Tiff Macklem: Raising the house of reform Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the Rotman Institute for International Business, Toronto, Ontario, 7 February 2012. * * * Introduction It is a pleasure to be here this morning. I want to thank the Rotman Institute for International Business, and particularly its co-directors, Wendy Dobson and Ig Horstmann, for inviting me. Like many of us, I have benefited tremendously from Wendy’s insight, her ruthless truth telling and her sage advice on international issues. Ig Horstmann was one of my professors in graduate school. And I owe him a debt of gratitude for turning an enthusiastic student of macroeconomics on to the importance and utility of microeconomics – training that has proven invaluable in grappling with issues of financial regulation. My remarks today combine both these elements – international economics and financial regulation. I want to talk to you about the imperative of completing the reform of the global financial system. Some are calling for a slowdown of the reform process, arguing that a weak global recovery and elevated uncertainty are good reasons to ease up on implementation. The global economy is certainly underperforming. The euro area appears to have fallen back into recession, with a sovereign debt crisis that poses clear and present downside risks. In the United States, housing and labour markets have proven stubbornly slow to recover, and there is a large fiscal adjustment still to come. But the current challenges are not an excuse for delay. Quite the opposite – they underscore the urgent need to make the financial system more resilient. In a risky world, the need to make the financial system safer and restore confidence is vital. If there is a reproach to be made, it is that progress has not been faster. The G-20 Leaders’ 2009 plan of action to strengthen the financial system was appropriately sweeping. It included: enhanced transparency and disclosure so markets work better; larger capital and liquidity buffers to make banks safer; broadening the span of regulation and oversight so that all systemically important financial institutions, markets and products are included; stronger infrastructure so that core financial markets continue to function in periods of stress; and credible and effective resolution regimes for all financial institutions so that no institution is too big to fail. With the architecture for their house of reform sketched out, the Leaders assigned responsibility for the detailed design and construction to the Financial Stability Board (FSB). Now, almost three years later, construction is well underway. But it’s a big house with several wings. The foundation has been laid and the framing has been completed. Some wings are even ready for occupancy, while in others the walls are still going up. In my remarks today, I will focus on the key prerequisites for completing construction and the challenges of moving in. I will organize my remarks around the three Cs essential to get to completion: the need to be comprehensive, coordinated and consistent. BIS central bankers’ speeches Reform must be comprehensive, spanning institutions, markets and products, from inception to resolution. Reform must be coordinated across its many elements, across jurisdictions and with stakeholders. And reform must be implemented in a consistent manner around the globe. Comprehensive To ensure the reforms are comprehensive, work began at the core of the financial system and is now moving outward to the periphery. Three wings that will house the reforms to the core are now ready to move into. First, the new Basel III capital rules have been finalized and are now being implemented over a suitably gradual transition period. The new standard substantially increases the lossbearing capital that financial institutions must hold and establishes a new limit on leverage. This is a significant strengthening of the global rules, effectively raising the minimum global capital requirement sevenfold. Second, a methodology to assess systemic importance has been developed, and 29 banks have been identified as globally systemic. These banks are required to have additional lossabsorption capacity tailored to their systemic importance, ranging from 1 per cent to 2.5 per cent of risk-weighted assets, to be held in common equity. They will also be subject to closer scrutiny by bank supervisors. Third, to be able to resolve firms – no matter how large – without disruption to the economy or cost to taxpayers, the FSB has developed a new international resolution standard. Work is now turning to the implementation of the Key Attributes for Effective Resolution. By the end of this year, global systemically important financial institutions (SIFIs) will have completed: resolvability assessments; recovery and resolution plans; and institution-specific, cross-border co-operation agreements so that home and host authorities are better equipped to deal with crises. The sooner we move in, the sooner we roll back too big to fail. Other wings of the house are at various stages of construction. Permit me a few words about each. Liquidity standards The construction of new minimum standards to enhance banks’ liquidity buffers is well advanced, but needs some remodelling before completion. The current definition of highquality liquid assets is too narrow, focusing only on sovereign debt and cash. This may have the unintended consequence of increasing segmentation and reducing liquidity in some financial markets. Consideration should be given to broadening the definition to allow for a continuum of asset types, with suitable haircuts and limits. Systemically important financial institutions With additional protections for global SIFIs agreed, work is now under way to extend extra resiliency requirements to banks that are not globally systemic but are systemic at the national or domestic level. This includes developing an appropriate methodology for identifying domestic SIFIs, and outlining prudential measures to mitigate the risks they pose. BIS central bankers’ speeches Given the significant differences across countries in the structure of national banking systems, this framework should adopt a principles-based approach so that regulators have the flexibility to focus on the additional requirements that will be most effective within their domestic context. The systemic risks posed by other types of financial institutions and financial infrastructures are also being reviewed. The International Association of Insurance Supervisors (IAIS) is developing a methodology to identify activities of insurance companies that are systemically important on a global scale, including both traditional insurance and ancillary activities. Once the nature of their systemic activities has been identified, consideration will need to be given to any additional buffers that may be required – a task made more difficult by the lack of an international prudential accord for insurance companies. The Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) are currently developing safety and soundness principles for financial market infrastructures, such as central counterparties (CCPs). Work is also under way to examine the systemic activities of other types of non-bank financial firms or so-called shadow banks. Shadow banking Drawing the systemic elements of shadow banking into the regulatory net was a central element of the G-20 Leaders’ reform vision. They agreed that regulation and oversight should depend on the nature of the activity – not legal structure – and that like activities should receive like treatment. In many countries, including Canada, market-based financing or shadow banking is at least as large as the traditional banking sector. Shadow banking spans a range of activities, including repurchase agreements, mortgage-backed securities, other types of securitization, short-term debt instruments and money market mutual funds. The sector provides competition to traditional banking and is an important source of diversification and innovation. But it also entails many of the same risks that are inherent in traditional banking. Like the credit intermediation of banks, shadow banking involves liquidity and maturity transformation, often with some degree of leverage. Moreover, as the financial crisis made painfully clear, the systemic risks of shadow-banking activities can be magnified by the interconnectedness of the financial system – stresses within shadow banks can be transmitted to the core of the financial system in unforeseen ways. Foundational elements to achieve more comparable treatment are now in place, including enhanced disclosure requirements, the new consolidation accounting standard and minimum risk-retention rules. But much work is needed on the full range of policy options to control systemic risks in the shadow-banking sector. These include: direct regulation of the activities of shadow banks; indirect regulation via links to the traditional banking sector; targeting specific products; and various macroprudential measures. By the end of 2012, the FSB, with the relevant standard-setting bodies, will develop policy recommendations on shadow banking in five priority areas: the interactions of regulated banks with shadow banking entities and activities; money market mutual funds; other shadow-banking entities; securitization; and securities lending and repos. Policy reforms in all of these areas should be guided by four considerations. BIS central bankers’ speeches First, with the capital and liquidity standards applied to banks set to increase, we can expect to see new incentives for activities to migrate to the shadow-banking sector, increasing the need for timely reform. Second, the reforms must strike an effective balance between the benefits of shadow banking, in terms of competition, diversification and innovation, and the risks related to regulatory arbitrage and systemic vulnerabilities. Third, given the important differences in the structure of shadow-banking activities across countries, the best means of mitigating systemic risks is likely to differ across jurisdictions. But given that shadow-banking activity crosses national borders, there is a need for a coherent global approach to these issues. Fourth, the reforms and the approach to monitoring the sector must be flexible and adaptable, since changes in regulation and innovation can lead to rapid expansion and mutation of shadow-banking activities. Central counterparties for OTC derivatives The final element of the comprehensive reform plan is mitigating contagion between sectors and institutions in the financial system. The house needs firewalls. Recognizing this imperative, the G-20 Leaders mandated that all standardized OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through CCPs. In addition, all OTC derivatives trades should be reported to trade repositories. The architecture for trade repositories is converging on a global platform, although important issues of data access are still to be worked out. For CCPs, the basic architecture has yet to be resolved. There are two competing designs – global and local – and each has its costs and benefits. The global design has the greatest potential to reduce fixed costs, maximize netting benefits and economize on collateral. At the same time, these very benefits would concentrate clearing risk in a small number of very large global CCPs. They could also create a competitive advantage for the largest global banks, serving to reinforce their systemic importance. The alternative is a more distributed model in which local CCPs are established to clear OTC derivatives transactions outside the United States and the European Union. While this design would reduce concentration and provide for greater competition, it could result in an overly fragmented architecture, with local CCPs that are not sufficiently efficient and robust. To inform decisions on architectural design, the FSB, working with the standard setters, is coordinating efforts to develop adequate safeguards for a global architecture, especially with regard to access, cross-border emergency liquidity arrangements, co-operative oversight and resolution. The goal is to complete the work on these safeguards by June so that each jurisdiction can make an informed choice about its preferred clearing architecture this year. Coordinated Let me now turn to the second C – coordinated. Reform elements must be balanced, coherent, mutually reinforcing and well integrated. The FSB’s overarching role is to ensure global coordination across all the elements of reform and across countries. Coordination across the elements means we must consider the combined effect of the totality of the reforms, including both their cumulative impact and their interaction. We should avoid BIS central bankers’ speeches overreliance on one instrument, and strive for balance. For example, as the experience of some firms in the financial crisis highlighted, even strong capital levels, by themselves, do not provide adequate protection. While important, capital buffers need to be buttressed with sound risk management, a leverage cap, liquidity requirements and measures to limit contagion. Coordination across countries requires a coordinating process. Historically, responsibility for financial sector policy has been spread across national agencies as well as international standard-setting bodies. The crisis underscored the importance of the FSB’s key coordinating role. Now chaired by Bank of Canada Governor Mark Carney, the FSB is acting on a clear remit from the G-20. As the general contractor in the reform process, the FSB coordinates all aspects of construction. Over the past four years, the FSB has undertaken much of the policy work itself through its standing committees, while other aspects of construction have been subcontracted to international standard-setting bodies, including the Basel Committee, CPSS and IOSCO. The FSB’s responsibilities loop from conception to feedback. The FSB takes the lead in identifying critical financial vulnerabilities, developing new policies and then assessing their implementation and effectiveness (Figure 1). These efforts are being undertaken in coordination with the private sector. Broad consultation is essential to effective design. To steal a line from the late Michael Mussa on the perils of seeking input from just one kind of specialist, if you only consult plumbers, every room is going to have a toilet. Reform proposals are being developed in consultation with the financial community and released for public commentary and input from industry round tables. Consistent That brings me to the third C – consistent implementation. If the new global standards are to promote international financial stability, they must be consistently implemented across the major financial jurisdictions. Consistent does not mean BIS central bankers’ speeches one size fits all. Most standards, such as the Basel capital rules, are international minimums. Countries can adopt stronger rules or, as Canada is doing with Basel III, implement more quickly than the generous maximum phase-in period. The monitoring of implementation is coordinated by the FSB’s Standing Committee on Standards Implementation, which I chair. Assessment has proceeded along two complementary tracks: country reviews that examine the implementation of standards in a single FSB member country, and thematic reviews that focus on one element and assess implementation across the 24 FSB member countries. Six country peer reviews have now been completed, most recently for Canada and Switzerland. And five thematic peer reviews have examined implementation across the full FSB membership on topics ranging from compensation practices at banks, to mortgage underwriting standards and deposit insurance systems. So the FSB peer review system is up and running. But already it is time for expansion. To assess consistency in the implementation of major reforms, we are significantly enhancing the resources devoted to monitoring, and coordinating implementation-monitoring activities across the standard-setting bodies and the FSB. This will include annual progress reports to the G-20 on a country-by-country basis, as well as less-frequent but more in-depth peer reviews in priority areas. Some commentators are concerned that the FSB lacks the authority to enforce the rules, and have argued that it must evolve to a treaty-based organization with the power to sanction its members. While this may ultimately prove to be the case, so far, this has not been demonstrated. The FSB is making good progress on the basis of consensus and cooperation. Peer reviews have reported that implementation is moving ahead, have identified remaining gaps and have increased the focus on impediments to implementation. Countries that are not complying have been called out. But tougher tests lie ahead, and it is essential that the spirit of internationalism and cooperation is sustained. Implementing Basel III is the biggest and most immediate test. The Basel Committee is taking primary responsibility for monitoring and reporting on national implementation of Basel III. The committee will first look at whether each member’s financial system legislation is consistent with the Basel III requirements, and then at whether the riskweighting rules are applied similarly across countries. It will conduct and publish country-bycountry reviews and provide the FSB with an assessment of progress and gaps. If there are material deviations from Basel III, they will need to be fixed. Full and consistent implementation is imperative. Conclusion Allow me to conclude. The global financial system must be flexible enough to respond to the dynamics of the global economy. But it must also be able to retain its structural integrity in the face of powerful cross-currents generated by multi-polar economic development, rapid technological innovation and increasing financial globalization. The reforms we are constructing to house the financial system will allow us to track and identify emerging vulnerabilities and promote its stability. The goal is a dynamic and resilient financial system that serves the needs of households and businesses in good times and in bad. The FSB is building the reforms on a foundation of consensus among G-20 members. Despite its small size, the FSB has accomplished a great deal in just two and half years. Now it needs to reach out and network to foster closer relationships with international financial institutions, standard-setting bodies and non-member countries. The FSB also needs to be placed on a more secure footing if it is to be an enduring pillar of the international financial architecture. To that end, the G-20 Leaders agreed at the Cannes Summit last November that the FSB should expand its resources, and gain legal personality BIS central bankers’ speeches and greater financial autonomy. This will extend the FSB’s capacity to coordinate, monitor and assess financial reform. But, ultimately, it is up to the FSB’s member countries to ensure that the house of reform becomes the home to the financial system. Full implementation is the responsibility of every member. We should expect no less. Thank you. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the 2012 US Monetary Policy Forum, sponsored by The Initiative on Global Markets, University of Chicago Booth School of Business, New York City, 24 February 2012.
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Mark Carney: A monetary policy framework for all seasons Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the 2012 US Monetary Policy Forum, sponsored by The Initiative on Global Markets, University of Chicago Booth School of Business, New York City, 24 February 2012. * * * Introduction It is a pleasure to be at the U.S. Monetary Policy Forum, which brings together academics, practitioners and market participants to discuss current issues in monetary policy. There are a few. Indeed the crisis has shaken the foundations of monetary economics, making this a great time to be an academic but a more challenging one to be a practitioner. The extent to which market participants enjoy the situation appears to fluctuate on a daily basis. In the crisis economies, policy-makers are battling the possibility of deflation. They are handicapped by transmission mechanisms that are at best impaired and at worst broken. With households and banks in these economies aggressively trying to delever, output gaps remain large and hysteresis threatens. As a consequence, the horizons of monetary policy have been expanded dramatically. The Federal Reserve has been appropriately and effectively radical by implementing a range of powerful unconventional tools. Market expectations that G-3 target rates will stay at very low levels for a very long time appear firmly entrenched. G-3 central bank balance sheets have swelled to about 25 per cent of GDP, on average, and can reasonably be expected to expand further. In the non-crisis economies, the challenging external environment has also required bold policy actions. Financial and confidence spillovers from the major financial centres are creating material headwinds. Weak export demand is forcing a heavy reliance on domestic demand to maintain momentum. Despite well-functioning domestic financial systems, policy rates remain near historic lows and real rates are generally negative. For these economies, the possibility of a low-for-long world may contribute to excessive credit creation and risk taking. Moreover, an inflexible international monetary system is promoting large carry trades, with a bias to exchange rate overshooting, high correlations and significant volatility. Away from the cognoscenti, understandable frustrations have risen. Citizens want their confidence in the system restored so that they can get on with their lives. It is not surprising that, in the wake of these challenges, monetary policy frameworks are under intense scrutiny. Is there a simple answer in such a messy world? It might not surprise you that, as the governor of a central bank that helped pioneer inflation targeting, I will argue today that flexible inflation targeting remains the best response. This is not a lazy reflex. Over the past five years, the Bank of Canada has intensively examined alternatives to our current framework, including a lower inflation target and moving to a price-level target. We worked with the Government of Canada in a calm, reasoned BIS central bankers’ speeches review of these options and in full consideration of the lessons of the financial crisis. In the end, we reaffirmed our first principles. 1 We did so because, in a complex and continuously evolving world that no one can predict with certainty, policy-makers need a robust framework; one that remains appropriate no matter the circumstances. Inflation targeting is disciplined but flexible. It allows central banks to deliver what is expected while dealing with the unexpected. The death of inflation targeting? There are many who would take issue with this conclusion. Ignoring the reality that only one inflation-targeting central bank – the Bank of England – was at the epicentre of the crisis, some claim the crisis marks the death knell of arguably the most successful monetary policy framework ever. These opponents of inflation targeting make some variant of four main arguments. First, price stability does not guarantee financial stability. We at the Bank of Canada agree. 2 We have consistently pointed out that low, stable and predictable inflation can feed complacency among financial market participants, as risk taking adapts to the perceived new equilibrium. Indeed, risk appears to be at its greatest when measures of it are at their lowest. The tendency to overreach is particularly marked if there is a perceived certainty about the stability of low interest rates. In short, complacency can lead to extremes and, ultimately, crisis. But it does not follow that central banks practising flexible inflation targeting are forced to be similarly complacent when faced with the buildup of financial imbalances, a point to which I will return later. Second, the stronger critique of the Austrian school is that inflation targeting can actively feed the creation of financial vulnerabilities, especially in the presence of positive supply shocks. For example, in an environment of increased potential growth resulting from higher productivity, inflation-targeting central banks may be compelled to respond to the consequent “good” deflation by lowering interest rates. From the Austrian perspective, this misguided response stokes excess money and credit creation, resulting in an intertemporal misallocation of capital and the accumulation of imbalances over time. These imbalances eventually implode, leading to crisis and “bad” deflation. 3 As I will argue later, this critique places monetary policy in a vacuum divorced from broader macroprudential management. Moreover, it offers only a counsel of despair for current problems: liquidate, liquidate, liquidate. Third, the opposite concern (voiced by Joe Stiglitz among others) is that inflation-targeting central banks will prove to be “inflation nutters” in the post-crisis environment. 4 We are portrayed as obsessed with a narrow inflation target while the economy burns. But in the post-crisis environment of deficient demand, preventing the economy from burning is entirely consistent with preventing inflation from falling below the target. As should be obvious from the actions of inflation targeters ranging from the Bank of England to the Bank of Canada and now the Fed, the framework has encouraged, rather than discouraged, aggressive easing. Bank of Canada, “Renewal of the Inflation-Control Target: Background Information – November 2011.” M. Carney, “Some Considerations on Using Monetary Policy to Stabilize Economic Activity,” speech to a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 22 August 2009. W. White, “Is Price Stability Enough?” BIS Working Papers No. 205, Bank for International Settlements, 2006. J. Stiglitz, “The Failure of Inflation Targeting,” Project Syndicate, May 2008. BIS central bankers’ speeches Finally, some have argued that an inflation target consistent with price stability is too low for a post-crisis world. While the recovery is proceeding in crisis economies, it remains weak, particularly relative to the depth of the recession. This is consistent with the historical experience following financial crises. Indeed, it is only with justified comparisons to the Great Depression that the success of the U.S. policy response is apparent. Although the details differ by country and region, banks, governments and households across the crisis economies are trying to deleverage. One response to smooth this process could be to retain the inflation-targeting framework but raise the level of the target, as Rogoff and others have argued. However, this is not the kind of flexibility we have in mind when we speak of “flexible IT.” Moving opportunistically to a higher inflation target would risk unmooring inflation expectations and destroying the hard-won gains that have come from the entrenchment of price stability. A higher inflation-risk premium might result, prompting an increase in real rates that would exacerbate unfavourable debt dynamics. The most palatable strategy to reduce debt is to increase growth. In today’s reality, the hurdles are significant. For example, in Europe, sustained and necessary structural reforms may, for a time, actually depress nominal growth. The repair of U.S. household balance sheets has yet to fully run its course. Japan’s adjustment remains a work in progress. As a consequence, the advanced economies could face a prolonged period of deficient demand and weak nominal growth. The central challenge for monetary policy-makers in this environment is to prevent that from happening. The clock is ticking: the longer that crisis economies and their jobs markets remain moribund, the greater the risk of failure. Would targeting the nominal GDP level be superior? The broad deleveraging headwinds in crisis economies call for accommodative monetary policy. This is why, four years after the onset of the crisis, policy rates in these economies are still at or close to their zero lower bound (ZLB) and unconventional policy actions are still expanding. 5 To the extent that more monetary stimulus is needed, some have suggested that nominal-GDP (NGDP) targeting could be a powerful approach to facilitate the deleveraging process. Under this option, the central bank would seek to make up for any undershoot in the trend in the value of nominal output. The actual undershoots in crisis economies have been significant, reaching about 10 per cent in the United States and the United Kingdom – or nearly two trillion dollars combined. Committing to restore the level of nominal GDP to its pre-crisis trend could lend the powerful boost to expectations needed to reduce real debt burdens and, more generally, provide added stimulus to the economy through lower real interest rates. 6 S. Kozicki, E. Santor, and L. Suchanek, “Unconventional Monetary Policy: The International Experience with Central Bank Asset Purchases,” Bank of Canada Review (Spring 2011): 13–25. More generally, NGDP-level targeting seeks to target a level of nominal GDP growing at the rate of the inflation target – say 2 per cent – plus the long-term potential growth of the economy. For economies like the United States and Canada, that would mean keeping NGDP on a path that would grow at a rate between 4 and 5 per cent. The central bank would ease monetary policy when the level of NGDP is (expected to be) below the targeted path and tighten if it is (expected to be) above. Should NGDP fall below target in a particular year, bygones would not be bygones: the central bank would seek to make up for that in subsequent years. BIS central bankers’ speeches As Woodfordian logic would have it, a key appeal of NGDP-level targeting is that by compensating for past deviations from desired levels – i.e., by introducing more dependence on history – it would better harness the power of expectations to stabilize the economy. 7 In normal times, these greater stabilization benefits are not likely to be particularly important. As part of the work leading to the renewal of our inflation control agreement, the Bank of Canada analysed the benefits of price-level targeting (PLT) which, like nominal GDP targeting, is a way to introduce history dependence. Our research shows that, apart from lower bound episodes, the gains from better exploiting the expectations channel are likely to be modest. Based on simulations using the Bank’s main projection model, the benefits of this greater stabilization under PLT are comparable to a permanent quarter-point reduction in the standard deviation of CPI inflation, a significantly smaller improvement than that realized upon the introduction of inflation targeting in Canada in the 1990s. Much of this benefit arises following shocks that create an explicit trade-off between output and inflation stabilization, such as supply shocks, since credible and well-understood PLT improves this trade-off. To reap even these modest gains, expectations would have to adjust the way theory says they should. That requires the change in policy regime to be both credible and well understood. The public would need to be fully conversant with the implications of the regime and trust policy-makers to live up to their commitment. These conditions may not be met. In the worst case, if nominal GDP targeting is not fully understood or credible, it can, in fact, be destabilizing. Our research shows that the stabilization benefits of PLT appear to diminish quickly as the fraction of the population that behaves in a manner consistent with PLT falls, and are eliminated when this fraction reaches 50 per cent. 8 We have also investigated more directly – in a laboratory-type setting – how people would adapt to a PLT regime. Our results suggest that while people do change their behaviour under PLT, the changes reflect an imperfect understanding of the implications of the regime. 9 More fundamentally, relative to PLT and IT, nominal GDP-level targeting imposes some additional restrictions that might impede the ability of the central bank to achieve its underlying goal of maximizing welfare. NGDP-level targeting treats changes in overall prices and real activity as a package. As potential growth changes over time, either the nominal target will have to change or else it will force an arbitrary rebalancing between inflation and real activity objectives. Through several influential papers, Michael Woodford espouses history dependence as a necessary feature of optimal monetary policy under commitment. History dependence requires that the monetary policy instrument respond to past economic conditions, in addition to current and expected future conditions. For example, following a shock that initially causes inflation to rise, a history-dependent policy would to continue to maintain real interest rates above their natural rate, even after the effect of the shock has fully dissipated, thereby causing inflation to eventually undershoot its pre-shock level. Other things being equal, such a policy is destabilizing precisely because it causes this secondary cycle in inflation. However, Woodford shows that if private agents correctly anticipate this type of policy response when setting prices at the time the shock occurs, the initial rise in inflation will be smaller, and this can more than offset the subsequent secondary cycle. See M. Woodford, “Pitfalls of Forward-Looking Monetary Policy,” American Economic Review 90 no 2 (2000): 100–104; “The Taylor Rule and Optimal Monetary Policy,” American Economic Review 91 no 2 (2001): 232–37; “Optimal Interest-Rate Smoothing,” Review of Economic Studies 70 no 4 (2003): 861–86; and M. Woodford, “Optimal Monetary Stabilization Policy,” in Handbook of Monetary Economics, vol. 3B, edited by B. Friedman and M. Woodford (Amsterdam: Elsevier, 2011) 723–828. S. Murchison, “Consumer Price Index Targeting,” Bank of Canada (forthcoming). R. Amano, J. Engle-Warnick and M. Shukayev, “Price-Level Targeting and Inflation Expectations: Experimental Evidence,” Working Paper No. 2001–18, Bank of Canada, 2011. BIS central bankers’ speeches In addition, under NGDP-level targeting, the central bank would seek to stabilize the GDP deflator in order to achieve price stability. But the GDP deflator measures the price level of domestically produced goods and services, which may not match up well with the cost of living that the CPI measures and that matters most for welfare, particularly in small, open economies where imports make up a substantial share of the consumption basket. All of that said, when stuck at the zero lower bound, there could be a more favourable case for NGDP targeting in providing additional stimulus and better facilitating the deleveraging process in the aftermath of a financial crisis. The exceptional nature of the situation, and the magnitude of the gaps involved, might make such a policy more credible and easier to understand. Depending on the depth and duration of the ZLB episode, our calculations suggest that the adoption of a (temporary) price-level target, if well understood and credible, could eliminate more than half of the losses associated with the impossibility of providing additional monetary stimulus through a lower policy rate. NGDP-level targeting may thus merit consideration as a temporary unconventional monetary policy tool. But NGDP targeting does not, in our view, amount to a complete policy framework. What is needed is a robust framework that remains appropriate and well understood under any circumstances. Why flexible inflation targeting provides a robust framework Flexible IT is such a framework for all seasons. The flexible IT framework in place in Canada since 1991 (similar to the one recently adopted by the Fed) focuses on a medium-term inflation goal. This is a means to an end, the end being economic well-being. The central bank focuses on this goal because it is both immutable and achievable. The way in which we achieve the goal can be adjusted, depending on the circumstances. This flexibility is important to be able to stabilize other aspects of the economy that also matter, but for which the desirable level can change over time or depending on the circumstances. Thus, under flexible IT, the central bank seeks to return inflation to its medium-term target while mitigating volatility in other dimensions of the economy that matter for welfare, such as employment and financial stability. For most shocks, these goals are complementary. However, for shocks that pose a trade-off between these different objectives, or that tilt the balance of risks in one direction, the central bank can vary the horizon over which inflation is returned to target. 10 The exercise of this flexibility cannot be arbitrary, and it requires a clear and transparent communications approach, which is important to both the accountability and effectiveness of monetary policy. This is why the Bank regularly reports its perspective on the forces at work on the economy and their implications for the path of inflation, including the horizon over which inflation is expected to return to target. 11, 12 When credible, flexible IT provides a disciplined framework that can best adapt to changing and complex circumstances in order to best stabilize the economy. That makes the IT Bank of Canada, “Renewal of the Inflation-Control Target: Background Information – November 2011.” For example, see various issues of the Bank of Canada’s quarterly Monetary Policy Report. Typically, the Bank seeks to return inflation to target over a horizon of six to eight quarters. However, over the past 20 years, there has been considerable variation in the horizon, in response to different circumstances and economic shocks. At times, the horizon over which inflation was projected to return to the 2 per cent target has been as short as two quarters and as long as 11 quarters. There have been nine occasions when the Bank has extended the target horizon beyond eight quarters. BIS central bankers’ speeches framework robust, as is demonstrated by its ability to deal with the very different challenges faced by both crisis and non-crisis economies. Flexibility for crisis economies In the crisis economies, the challenge for central banks is to sustain aggregate demand in a period of important real adjustments. Flexible IT is well suited to this purpose. The commitment to the inflation target ensures price stability by anchoring inflation expectations over the medium term. At the same time, it provides a clear framework to carry out unconventional monetary policy to provide additional stimulus, as required, in the shorter term. While Canada was not, and is not, a “crisis” economy, our experience through the crisis is illustrative. The clarity and credibility of Canada’s inflation-targeting regime was a critical anchor through those turbulent times, giving the Bank an unwavering goal to guide its rapid and determined easing, and providing financial markets and the public with a clear means of understanding the rationale behind them. Within this framework, our first (and only) venture into unconventional monetary policy was, in April 2009, to conditionally commit to maintaining rates at their zero lower bound through mid-2010. 13 Being able to make this commitment expressly conditional on the outlook for inflation, and thus anchored in a well-understood goal, enhanced its effectiveness in providing the needed stimulus, as well as allowing us to adjust the guidance smoothly as conditions warranted. As the newest member of the flexible IT club, the Fed is now also able to use the anchor of an explicit inflation target to boost the aggressiveness of its communications strategy. We expect that the Fed’s elaboration of its longer-term policy goals will enhance the stimulative effect of its announcement that the federal funds rate is likely to remain at exceptionally low levels at least through late 2014. Extraordinary forward policy guidance within a flexible IT framework helped the Bank of Canada provide additional stimulus when it was needed and should help the Fed do the same. The Fed’s experience with a published interest rate path in conventional times, when they return, is something we will watch with interest. Flexibility for non-crisis economies The robustness of flexible IT benefits non-crisis economies as well. In a global economy, ties of trade, finance and confidence bind both crisis and non-crisis economies together. With the global economy underperforming and the recovery still fragile, shocks can be felt far from their origins. With flexible IT, non-crisis economies can more easily absorb the shocks from global headwinds by continuing to keep inflation low, stable and predictable so that households and firms can invest and plan for the future with confidence. Let me illustrate with a few practical examples from our experience in Canada. As the recovery unfolded, the Bank maintained an easier stance of policy than would have been implied by a simple Taylor-type rule (where the overnight rate mechanically responds to deviations of current inflation from the target). This allowed us to bring inflation back to target and output back to potential more quickly by leaning more heavily into the sustained See the April 2009 issue of the Bank of Canada’s Monetary Policy Report. BIS central bankers’ speeches headwinds of weaker foreign demand. 14 IT also allowed us to guide market participants that, in an environment of material external headwinds, closing the output gap did not necessarily correspond with returning the policy rate to neutral. This illustrates that, in a complex and continuously evolving world, it is illusory to think that the mechanistic implementation of a simple rule would prove desirable for all the circumstances that monetary policy must face. Not only does a flexible IT framework enable the central bank to deal with shocks, it also provides the flexibility to address a buildup of financial vulnerabilities that a low-for-long environment can fuel. This is important as 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 by banks, firms and households. 15 Concerning levels of household debt can build in non-crisis economies, as they have in Canada, where a well-functioning financial system has combined with an environment of low interest rates since 2008. The first line of defence against a buildup of such financial imbalances is micro- and macroprudential regulation and supervision. Canadian banks are currently reinforcing their already strong capital positions in order to meet the Basel III requirements for 2019 by the start of next year. The Government of Canada has already made three timely and prudent adjustments to the terms of mortgage finance. Canadian authorities are co-operating closely and will continue to monitor the financial situation of the household sector. These defences will go a long way to mitigate the risk of financial excesses, but in some cases, monetary policy may still have to take financial stability considerations into account. This is most obviously the case when financial imbalances affect the near-term outlook for output and inflation. In exceptional circumstances, when financial imbalances pose an economy-wide threat or where imbalances themselves are being encouraged by a low interest rate environment, monetary policy itself may be needed to support financial stability. Monetary policy has a broad influence on financial markets and on the leverage of financial institutions that cannot easily be avoided. This bluntness makes monetary policy an inappropriate tool to deal with sector-specific imbalances but a valuable one to address imbalances that may have economy-wide implications. 16 Technical Box 2 in the Bank of Canada’s July 2011 Monetary Policy Report, “Headwinds, Tailwinds and the Policy Rate,” pages 28–29. S. Cociuba, M. Shukayev and A. Ueberfeldt, “Do Low Interest Rates Sow the Seeds of Financial Crises?” Working Paper No. 2011-31, Bank of Canada, 2011; H. Damar, C. Meh and Y. Terajima, “Leverage, Balance Sheet Size and Wholesale Funding,” Working Paper No. 2010-39, Bank of Canada, 2011; T. Paligorova and M. Santos, “Bank Risk-Taking in Episodes of Easy Monetary Policy,” Bank of Canada Working Paper (forthcoming 2012); and Bank of Canada, “Renewal of the Inflation-Control Target: Background Information – November 2011”. See also T. Adrian and H. Shin, “Financial Intermediaries and Monetary Economics,” in Handbook of Monetary Economics, vol. 3A, edited by B. Friedman and M. Woodford (Amsterdam: North Holland, 2010), 601–50; R. Rajan, “Has Finance Made the World Riskier?” European Financial Management 12, no. 4 (2006): 499–533; and G. Jiménez, S. Ongena, J. Peydró and J. Saurina, “Credit Supply and Monetary Policy: Identifying the Bank Balance-Sheet Channel with Loan Applications,” American Economic Review (forthcoming). J. Boivin, T. Lane and C. Meh, “Should Monetary Policy Be Used to Counteract Financial Imbalances?” Bank of Canada Review (Summer 2010): 23–36 and Bank of Canada, “Renewal of the Inflation-Control Target: Background Information – November 2011.” F. Mishkin, “Monetary Policy Strategy: Lessons from the Crisis,” Working Paper No. 16755, National Bureau of Economic Research, 2011 and I. Christensen and C. Meh, “Countercyclical Loan-to-Value Ratio and Monetary Policy” (Bank of Canada, forthcoming), argue further that BIS central bankers’ speeches A virtue of flexible IT is that if the regime is credible, the inflation target can anchor inflation expectations while leaving room for policy-makers to occasionally use monetary policy for financial stability purposes. The Bank of Canada’s policy interest rate has remained at its current level of 1 per cent for more than a year – a degree of stimulus appropriate to an environment where the Canadian economy faces considerable external headwinds. In its latest Monetary Policy Report, the Bank projected that this accommodative policy stance – with a gradual reduction in monetary stimulus over the projection horizon – would be consistent with returning inflation to the 2 per cent total CPI inflation target in seven quarters, in line with the typical monetary policy horizon. As I have discussed, however, a key feature of Canada’s inflation-targeting framework is the scope to adjust this horizon if circumstances warrant. Equipped with this flexibility, 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. Conclusion The post-crisis world presents economists, academics and policy-makers with many challenges. Chief among them is the conduct of monetary policy during a period of profound adjustment during which deflation, inflation and financial stability risks could all threaten. The Bank of Canada believes flexible inflation targeting provides a robust framework for all seasons, and we will use its full potential to deliver price stability and to enhance the economic welfare of Canadians. a general understanding that monetary policy will be employed to counteract the buildup of such risks and imbalances is likely to enhance the stabilizing impact of this approach. BIS central bankers’ speeches
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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the Brazil-Canada Chamber of Commerce, São Paulo, Brazil, 12 March 2012.
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Tiff Macklem: Promoting growth, mitigating cycles and inequality – the role of price and financial stability Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the Brazil-Canada Chamber of Commerce, São Paulo, Brazil, 12 March 2012. * * * Introduction Good afternoon and thank you for the kind invitation to speak to the Brazil-Canada Chamber of Commerce. The climates and geographies of Brazil and Canada couldn’t be more different. Yet our countries have much in common. We are both resource- and land-rich – Canada is the world’s second-largest country, Brazil the fifth largest. We are both among the world’s top 10 oil producers. We share a democratic system of government and market-based economies. And our monetary policies are both anchored by an inflation target with a flexible exchange rate. In recent years we both faced a global financial crisis that emanated from beyond our borders. We weren’t immune but came through it better than most. Among G-7 countries, Canada had the shortest recession and one of the strongest recoveries. The recession in Canada lasted three quarters and our GDP is now 3.3 per cent above its pre-recession peak. Even more impressive is the recovery in Brazil, which returned to growth after just two quarters. Your GDP is now 8.2 per cent above its pre-recession peak. Globally, the cost of the crisis has been enormous. The ensuing recession was the worst the world has seen since the 1930s and the most globally synchronous in history. Almost 28 million jobs disappeared. Output losses to the global economy amounted to at least US$4 trillion. The recoveries in the United States and the euro area are the weakest since the Great Depression and risks are elevated. These global headwinds continue to challenge the Brazilian and Canadian economies. The devastation wrought by the crisis has focused attention on rising levels of income inequality in most advanced countries. The ensuing recession inflicted the greatest hardship on the most vulnerable. And this comes against the background of a disquieting trend. Not only have lower- and middle-income households borne a disproportionate share of the cost of the Great Recession, they reaped less than their proportional share of the income gains during the Great Moderation. Those gains were skewed to higher-income households. The growing disparity between rich and poor has prompted young people and business leaders, workers and the unemployed, and academics and policy-makers alike to ask some fundamental questions – first, about the role and structure of the financial system and, more recently, about capitalism itself. From the supporters of the Occupy Wall Street movement to the editors at the Financial Times, the market economy is under acute scrutiny. In my remarks today I want to address these concerns. I have three main messages. First, markets work better than anything else at delivering opportunity and prosperity. Second, an efficient and resilient financial system is an essential enabler to growth and inclusion. But, third and critically, markets only work well within sound policy frameworks. All markets – and financial markets in particular – need clear rules, diligent oversight, and consistent enforcement of the rules. Systemic crises are not the inescapable product of capitalism, and inequality is not the necessary by-product of growth. BIS central bankers’ speeches Central banks play an important role in supporting well-functioning markets by promoting both price and financial stability. These are essential public goods that sustain growth and mitigate cycles and inequality. Growth, cycles and inequality Over the past quarter century, steady advances in transportation, communication, and information technologies, underpinned by the widespread adoption of market-based economic policies, have globalized and expanded economies everywhere, especially those of Brazil, India and China. Never in history has economic integration involved so many people, such a variety of goods, and so much capital. This has dramatically narrowed the gap between rich and poor countries, lifted hundreds of millions of people out of poverty and created the potential for hundreds of millions more to share in the benefits. The shrinking disparity between the United States and China is particularly striking. In 1990, GDP per capita in the United States was almost 30 times higher than in China; by 2010, this ratio had fallen to just 6 times. However, at the same time as inequality between countries has been declining, the gap between rich and poor within many countries has increased (Chart 1). Countries as diverse as China, Denmark, Germany, Japan, New Zealand, Sweden, the United Kingdom and the United States have all seen inequality rise, as measured by their Gini coefficients.1 Again, to use the example of the United States and China, from the mid-1980s to the late 2000s, the Gini coefficient in the United States increased from 0.33 to 0.37, while inequality in China increased from 0.29 to 0.44. The most common measure of inequality, the Gini coefficient, ranges between 0, when everyone has exactly the same income, to 1, when only one person holds all the income. BIS central bankers’ speeches Among advanced countries, income inequality in the United States is at the high end of the range and has trended upward since the early 1980s. In 1981, the income share of the wealthiest 5 per cent of U.S. households was 16.5 per cent. By 2010, this share had increased to 21.3 per cent. Over the same period, the income share of the bottom 20 per cent shrank from 4.1 per cent to 3.3 per cent. With the onset of the crisis in 2007, the decline accelerated as rising unemployment affected workers at the lower end of the income distribution, particularly younger and less-educated workers. The last time inequality in the United States was so severe was during the 1920s. In short, market forces have been a powerful mechanism for creating wealth and narrowing the income gaps between countries. At the same time, however, globalization, combined with technological change, is concentrating wealth in fewer hands within many countries. Brazil and Canada Let me turn now to Brazil and Canada. The economic record of our countries in recent years provides an important counter-example to those questioning capitalism. In the face of the global crisis, neither country was obliged to bail out its banks. Our policy frameworks performed well under stress. And our economies proved resilient in the face of a global crisis. To an important degree, this outcome reflects the guidance we took from our own past mistakes in the 1980s and 1990s. Learning from bitter experience, Canada and Brazil put in place robust economic frameworks to support markets, including flexible inflation-targeting regimes, prudent fiscal policies, sound financial sector regulation and proactive oversight. In Canada we tend to compare our economic performance with that of the United States, for obvious reasons. Our financial systems and economies are highly integrated. So when the United States plunged into recession in the autumn of 2007, Canada was affected through trade, financial, and confidence channels. But with our well-regulated financial system, a credible monetary policy framework and a record of fiscal prudence, monetary and fiscal stimulus proved highly effective in dampening the cycle and spurring the recovery. This resilience had a profound impact on the relative performance of our labour market. The United States lost 8.6 million jobs in the recession and, despite the recent improvement in job creation, only about half of those jobs have been regained. In Canada, on a proportional basis we lost about 40 per cent of the jobs that were lost in the United States. Moreover, by early 2011 all of these had been recouped and employment is now 1.5 per cent above its level at the start of the recession in Canada (and 2.4 per cent above its level at the start of the recession in the United States) (Chart 2). BIS central bankers’ speeches In Canada, as elsewhere, low-income workers were hit hardest by the recession. But with a less-severe contraction in employment and a faster recovery, they fared far better than those in the United States. The unemployment rate for U.S. workers with less than a high school education almost doubled, rising from 10 to 19 per cent. And for younger workers aged 16 to 19, the rise in unemployment was even bigger, increasing from 15 to 26 per cent. By comparison, in Canada the unemployment rate among youth and the least educated rose by 4 to 5 percentage points (Chart 3 a, b). Similarly, while Canada has not escaped the trend toward higher levels of inequality, inequality in Canada is substantially lower than it is in the United States (Chart 4). Over the past quarter century, economic growth in Canada and the United States has been virtually the same, averaging close to 2.6 per cent. But Canada has achieved this comparable rate of growth with less inequality. I won’t presume to lecture you on the history of the reforms instituted here in Brazil, but I will suggest that the world needs to hear more about Brazil’s success story. The impact of the changes put in place more than ten years ago is both impressive and instructive. As the Brazilian economy became more open to the rest of the world and more market oriented, annual economic growth rose from about 2.4 per cent in the early 2000s to 7.5 per cent by the end of the decade. Brazil’s exports of goods and services, as a share of GDP, increased from 6.6 per cent in 1996 to 11.2 per cent in 2010.2 The most remarkable measure of success is that this step-up in growth was achieved with a declining rate of inequality – proof positive that economic growth isn’t inevitably shadowed by a widening gap between rich and poor. Inequality peaked in Brazil in the 1980s as the economy endured a series of crises, culminating in hyperinflation. But by the 1990s, growth and equality began to improve. With market-based reforms starting in the 1990s, combined with Brazil’s move to inflation targeting and a flexible exchange rate in 1999, fiscal reforms that put public finances on a sustainable track early in the 2000s, and social programs tied to education and health, this virtuous cycle accelerated (Chart 5). The decline in inequality has been significant, with the Gini coefficient falling from 0.60 to below 0.55. This combination of faster growth and declining inequality helped lift some 20 million Brazilians out of poverty between 2004 and 2009. Moreover, the potential to raise millions more out of poverty remains. Indeed, broader cross-country evidence suggests that lower inequality may in turn be good for sustaining growth. Based on the historical experiences of a broad sample of countries, recent research at the International Monetary Fund (IMF) suggests that for a country with median inequality (i.e., with a Gini coefficient of 0.40), a 10-percentile decrease of the Gini (to 0.37) increases the expected length of a growth spell by 50 per cent.3 Extrapolating from this study for the case of Brazil, these point estimates suggest that the decline in the Gini coefficient from 0.60 to 0.55 would be associated with a better than 75 per cent increase in the expected length of a growth spell, all other factors being equal. This bodes well for the future in Brazil. These figures are taken from the World Bank World Development Indicators database. A. Berg and J. Ostry, “Inequality and Unsustainable Growth: Two Sides of the Same Coin?” Staff Discussion Note No. SDN/11/08, International Monetary Fund, 2011; and A. Berg, J. Ostry and J. Zettelmeyer, “What Makes Growth Sustained?” Working Paper No. WP/08/59, International Monetary Fund, 2008. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches What can central banks do? How economies enter the virtuous circle of growth that both reduces inequality and is more sustainable is a complex subject involving a broad range of factors and the full array of policy frameworks, including education, health, openness to trade, foreign investment, financial development, and fiscal, labour market and environmental policies. Needless to say, these step well beyond the mandates and expertise of central banks. But within this matrix, central banks have two limited but important roles to play: promoting price and financial stability. Price stability Low, stable and predictable inflation promotes growth, mitigates economic cycles and protects the purchasing power of money. In 1991 the Government and the Bank of Canada adopted an inflation-targeting regime, which was renewed again in 2011 for another five years. Canadians have benefited in a number of important ways from this regime. An improved inflation environment has allowed consumers and businesses to manage their finances with greater certainty about the future purchasing power of their savings and income. Interest rates have also been lower in both nominal and real terms across a range of maturities. More broadly, low, stable and predictable inflation has helped to encourage more stable economic growth in Canada and lower and less-variable unemployment (Table 1). The reduced cyclical variability in unemployment has particularly benefited more vulnerable households. Unemployment rates for younger workers and those with less education are considerably more variable than those for well-educated, prime-age workers (Table 2). More stable economic growth in Canada in the 20 years since we began inflation targeting has reduced the cyclical fluctuations in unemployment for workers across all age and educational categories, but the largest declines in variability have been experienced by younger and lesseducated workers. Mitigating cycles is good for equality. Inflation control also offers a more direct benefit to lower-income households. Inflation is a tax on cash, and the proportion of household assets held in cash decreases as income rises.4 As a result, the burden of inflation borne by low-income households is significantly higher than for the wealthy. High and unstable inflation also imposes particular hardships on those individuals whose incomes do not keep pace with rising prices, especially people on fixed incomes, such as pensioners. Recent research at the Bank of Canada and elsewhere suggests that when inflation increases from 2 per cent to 5 per cent, average consumption by the poor declines by about 1.4 per cent, about four times the decline that occurs among the wealthy. And the drop in consumption among the elderly is about 1.8 times larger than that experienced by the young.5 D. Kessler and E. Wolff, “A Comparative Analysis of Household Wealth Patterns in France and the United States,” Review of Income and Wealth 37 no. 3 (1991): 249–66; A. Kennickell and M. Starr-McCluer, “Household Saving and Portfolio Change: Evidence from the 1983–1989 SCF Panel,” Finance and Economics Discussion Series 18, Division of Monetary Affairs, Federal Reserve Board, Washington D.C., 1996; A. Erosa and G. Ventura, “On Inflation as a Regressive Consumption Tax,” Journal of Monetary Economics 49, no. 4 (2002): 761–95; S. Cao, C. Meh, J.V. Rios-Rull and Y. Terajima, “Inflation, Demand for Liquidity and Welfare,” forthcoming paper, Bank of Canada (2012); C. Meh, J.V. Rios-Rull and Y. Terajima, “Aggregate and Welfare Effects of Redistribution of Wealth under Inflation and Price-Level Targeting,” 2010. Journal of Monetary Economics 57 (6), 637–52. S. Cao, C. Meh, J.V. Rios-Rull and Y. Terajima, “Inflation, Demand for Liquidity and Welfare,” forthcoming paper, Bank of Canada, 2012; A. Erosa and G. Ventura, “On Inflation as a Regressive Consumption Tax,” Journal of Monetary Economics 49, no. 4 (2002): 761–795. BIS central bankers’ speeches BIS central bankers’ speeches Financial stability Low, stable and predictable inflation promotes growth and can help mitigate cycles and inequality. However, the financial crisis has been a stark reminder that low inflation is no guarantee of financial stability. The causes of the financial crisis are many and complex. Its epicentre was the U.S. subprime-mortgage market, the growth of which was fuelled, in part, by rising levels of inequality as lower- and middle-income Americans took on more debt to compensate for stagnating incomes and wealthy investors searched for yield.6 The consequences have been severe and will be with us for years to come. History suggests that recessions following financial crises tend to be deeper, and the recoveries shallower. On average, the loss of output in a recession after a financial crisis is two to three times the loss in a normal recession. And typically, it takes output twice as long to return to its prerecession level after a financial crisis than after a normal recovery. Sadly, the recoveries in the United States and Europe show no signs of escaping this lesson from history. Both are experiencing the weakest recoveries since the Great Depression. The resulting unemployment, particularly long-term unemployment, is exacerbating inequality. In the United States and the euro area combined, more than 11 million workers have been out of work for more than a year. The other side of the coin is that an efficient and resilient financial system is essential to growth, and financial development has proven an important ingredient to reducing inequality. A well-functioning financial system is a key enabler to growth, channelling savings to productive investments, and helping households and businesses manage risks. Increasingly, cross-country evidence also suggests that financial development eases inequality by reducing transactions costs. This provides the opportunity to accumulate assets and smooth consumption, make financing accessible to local entrepreneurs, and promote inclusion in the formal economy. Recent research finds that financial development, measured as the ratio of private credit to GDP, both raises growth and reduces inequality. For the poorest quintile, 60 per cent of the benefit of financial development comes from overall economic growth and 40 per cent from greater income equality.7 In short, there is a virtuous circle of financial development, growth and reduced inequality. This points to the imperative of a dynamic and robust financial system. The excesses and abuses in the financial system that led to the crisis have been a lightning rod for public discontent. Understandably so. But the answer is not to dismantle the financial system. It must be rebuilt. That process is well under way.8 The G-20 financial reform agenda, launched in the depth of the recession, is suitably sweeping. Its key elements include: R. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton, N.J.: Princeton University Press, 2010). S. Jahan and B. McDonald, “A Bigger Slice of a Growing Pie,” Finance & Development (September 2011): 16–19; R. Levine, “Finance and Growth: Theory and Evidence,” in Handbook of Economic Growth, edited by P. Aghion and S. Durlauf, vol. 1 (Elsevier, 2005): 865–934; and T. Beck, A. Demirgüç-Kunt, and R. Levine, “Finance, Inequality, and Poverty: Cross-Country Evidence,” National Bureau of Economic Research Working Paper No. 10979, Cambridge, 2004. T. Macklem, “Raising the House of Reform,” speech to the Rotman Institute for International Business, Toronto, Ontario, 7 February 2012. BIS central bankers’ speeches capital and liquidity buffers to make banks safer; broadening the span of regulation and oversight so that all systemically important financial institutions, markets and products are included; stronger infrastructure so that core financial markets continue to function in periods of stress; and credible and effective resolution regimes for all financial institutions so that no institution is too big to fail. Many of these reforms are now being implemented. Others are still in the policy development stage. These reforms are not without costs. Higher capital and liquidity standards will raise the cost of funds. But the benefits of reducing the frequency and severity of crises are much larger. Under conservative assumptions, a cost-benefit analysis by the Bank of Canada suggests that strengthened international liquidity standards and a 2-percentage-point increase in bank capital ratios globally would generate net gains to Canada in present-value terms of about 13 per cent of GDP, equivalent to about $200 billion.9 The gains for the world economy are even greater, reflecting the higher historical frequency of crises globally. The cumulative net present value gain of these higher global standards is equivalent to more than 35 per cent of global GDP.10 Conclusion Let me conclude. Markets work better than anything else. They have proven over time to be the best generator of prosperity. But markets need to be guided by sound policy frameworks with clear rules that must be enforced with consistency and transparency. Effective inflation control, combined with well-regulated financial systems, are critical ingredients to sustained economic growth and shared prosperity. The forces of globalization and technological change that have propelled global growth and driven rising inequality within many countries are not likely to abate. We need to harness these sources of growth while increasing opportunity for all our citizens. Brazil is showing the world how. Thank you. Bank of Canada (2010), Report on “Strengthening International Capital and Liquidity Standards: A Macroeconomic Impact Assessment for Canada”. See also M. Carney, “Bundesbank Lecture 2010: The Economic Consequences of the Reforms,” speech delivered in Berlin, Germany, 14 September 2010. Basel Committee on Banking Supervision (BCBS) 2010 – An assessment of the long-term economic impact of stronger capital and liquidity requirements (LEI report) http://www.bis.org/publ/bcbs173.htm. Also Basel Committee on Banking Supervision/Financial Stability Board 2010 – Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements – (MAG report) http://www.bis.org/publ/othp10.htm. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the launch of the new 50 dollar bank note, Québec City, Québec, 26 March 2012.
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Mark Carney: Bank note launch Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the launch of the new 50 dollar bank note, Québec City, Québec, 26 March 2012. * * * Hello and welcome. It is a pleasure to be here to announce the launch of the new 50 dollar bank note. This bank note features a symbol of Canadian innovation and scientific excellence: the Canadian Coast Guard icebreaker and research vessel, the Amundsen. Today is also a celebration of the 50th anniversary of the Coast Guard. So we find ourselves in an ideal location, in Québec, a city with a rich maritime heritage. Icebreakers are an important part of the Coast Guard’s fleet, and it is entirely fitting to feature one on our currency. These new 50 dollar polymer bank notes, the second of our Frontiers series, will become available in banks throughout the country as of today. This series of bank notes is called “Frontiers” for two reasons. First, each bank note includes images that represent Canada’s exploits and achievements, particularly those in the sciences, technology or exploration. The image on this note is an example of expanding the frontiers of knowledge and understanding of the Arctic. The bank notes themselves have crossed a technological frontier. There is simply no other currency like it. These new notes feature a unique combination of transparent elements, holographic images, and other security features. They are the result of innovative technology and Canadian ingenuity, including research by the Bank of Canada and excellent collaboration among physicists, chemists, engineers and other experts in the bank note industry. Thanks to greatly enhanced security features and efforts undertaken by police forces, especially the Sûreté du Québec and the RCMP, as well as the support of financial institutions and retailers, counterfeiting rates have been reduced by 90 per cent since 2004. Issuing this new series of bank notes enables us to continue to stay ahead of counterfeiters. In addition to impressive security features to combat counterfeiting, these notes will last longer than those made from paper – at least two-and-a-half times longer – and will therefore be more economical and have a smaller environmental footprint. When they are eventually withdrawn from circulation, they will be recycled into other products here in Canada. Safer, cheaper, and greener: indeed, these new bank notes are a 21st century achievement of which all Canadians should be proud and in which they can have full confidence. This last point is very important. According to Bank of Canada research, when Canadians shop, they use cash for more than half of their transactions. They need a currency they can trust and the bank notes of this series are the most secure ever developed in the history of the Bank of Canada. Let us move now to the images that are on these bank notes; the Bank consulted citizens throughout their development. It was Canadians who told us they liked the new polymer material. And these citizens also gave us the ideas for themes. On the 50 dollar note you will see an image of the Amundsen, an icebreaker that keeps our oceans open to navigation. The Amundsen also undertakes search and rescue missions in the far north and serves as a research base where scientists from around the world come to work together. I think that Roald Amundsen, the great Norwegian explorer of both poles, would be very proud of the spirit of adventure, scientific excellence, and collaboration that are so apparent on the ship that bears his name. Thank you everyone for coming today. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Greater Kitchener Waterloo Chamber of Commerce, Waterloo, Ontario, 2 April 2012.
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Mark Carney: Exporting in a post-crisis world Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Greater Kitchener Waterloo Chamber of Commerce, Waterloo, Ontario, 2 April 2012. * * * Introduction It is an honour to help celebrate the 125th anniversary of the Greater Kitchener Waterloo Chamber of Commerce. Allow me to congratulate you for the work you have done and are doing to ensure that this is a “business building community.” This economy has been transformed since your Chamber was established. From its original mix of agriculture and basic manufacturing, the Kitchener-Waterloo region has become one of North America’s most diverse economic clusters. Through such nimbleness, this region has contributed to the 100-fold expansion of the broader Canadian economy over the Chamber’s lifetime. Of course, there have been occasional setbacks over the past 125 years, with more than 20 recessions, one depression and one near miss. In general, the recoveries that have followed have relied importantly on exports (Chart 1). However, this one is different. Exports still have not regained their pre-crisis peak, and in fact remain below their level of a decade ago. Canada has steadily lost global market share throughout this period. In my remarks today, I will discuss why this is happening and what can be done both in K-W and across Canada to respond to the underlying challenges. But allow me first to review Canada’s performance during the recession and recovery. BIS central bankers’ speeches A unique recession and recovery The broad economic strategy in response to the global financial crisis has been to grow domestic demand and to encourage Canadian businesses to retool and reorient to the new global economy. On the former, we have been successful. Even as pressure on the export-oriented manufacturing sector has intensified, domestically oriented sectors such as services and construction have remained resilient. With strong domestic fundamentals and a wellfunctioning financial system, stimulative monetary and fiscal policies proved highly effective in supporting a robust recovery – and now expansion – in domestic demand. Household expenditures have led the way, falling modestly through the recession and rebounding smartly since, to stand 6.5 per cent above their pre-recession peak. Owing to this resilience, Canada’s economy was the first of the G-7 countries to recover its recessionary decline in output and expand anew. Our labour market has bounced back too. All of the 430,000 jobs lost through the recession had been recovered as of early last year, and a further 180,000 jobs have been added since then. Most of the jobs created have been in the private sector and in industries paying above-average wages.1 More recently, unemployment has edged higher, even as the number of job vacancies continued to rise. This is consistent with structural shifts in the labour market, where workers in declining industries may not have the skills or experience to match immediately the needs of employers in expanding industries. The experience in Kitchener-Waterloo has broadly mirrored these national trends.2 As effective as the reliance on domestic demand in general and household spending in particular has been, the limits of this growth model are becoming clear. For example, the construction sector alone has accounted for about 100,000 of the new jobs created in Canada through the recovery, bringing its share of overall employment to its highest level in over 35 years. More broadly, household spending in Canada has been growing strongly for over a decade, both outright and relative to the economy as a whole. This spending has been supported by strong increases in real incomes, which rose a full percentage point faster than the rate of real GDP growth in the ten years leading up to the crisis. However, even these strongly rising incomes were not enough to finance the rapid growth in household spending. Canadians bridged the gap by tapping the wealth in their homes to finance up to one-fifth of consumption growth. As a result, household debt levels rose steadily relative to income through this period. Since the onset of the crisis, however, real income growth has been weaker and household spending has become more heavily dependent on stimulative financing conditions and high levels of net worth, notably house values. As a consequence, the debt burden has increased further. Moreover, much of the financing for the recent increases in household indebtedness has come from abroad. These trends are unsustainable over the medium term. 83 per cent are in the private sector; 90 per cent are in industries paying average or higher wages. A net 30,000 jobs have been created in the region since the trough of the cycle – almost double the number of jobs lost through the recession. The unemployment rate has fallen from a peak of more than 10 per cent to just below 7 per cent. BIS central bankers’ speeches What is needed now is greater focus on the second element of the broad economic strategy that I mentioned earlier – Canadian businesses retooling and reorienting to the new global economy. A deeper analysis of our trade performance proves the point. Export performance is lagging As I alluded to earlier, among the most striking features of the recent Canadian recession was the performance of exports. During the most intense phase of the Great Recession – a nine-month period beginning in the fall of 2008 – the level of Canadian exports plunged more than 16 per cent, or more than twice the total drop during the previous two cycles. By the end of last year, exports still remained roughly 8 per cent below their pre-recession peak. My core message today is that this recent performance brings into sharper relief major secular trends that have persisted over the past decade. As such, they will require a sustained response. Canada’s share of world exports has been declining since the turn of the millennium. In fact, our performance has been the second worst in the G-20 (Chart 2). Since 2000, Canada’s export growth was almost 5 percentage points slower than global export growth on average per year. Our share of the world export market fell from about 4.5 per cent to about 2.5 per cent and our manufactured-goods export market share has been cut in half. Consistent with this drop, employment in Canada’s manufacturing sector has fallen by more than 20 per cent, representing nearly half a million jobs. BIS central bankers’ speeches Decomposing the losses Broadly speaking, there are three possible explanations for Canada’s deteriorating export performance: we may be selling the wrong products; we may be selling to the wrong markets; or we may have become less competitive because of changes in our exchange rate, wages and relative productivity. A commonly held view is that our poor export performance is the result of competitiveness challenges, particularly the persistent strength of the Canadian dollar. There is some truth in that (Chart 3). Between 2000 and 2007, Canada’s unit labour costs rose 80 per cent relative to our trading partners – the largest such increase among OECD countries. Compared with the United States, Canadian unit labour costs rose by roughly 65 per cent. The majority of this increase reflected the appreciation of the Canadian dollar, although lower productivity growth in Canada versus the United States also played a significant role, a phenomenon seen across export sectors (Chart 4). However, it is telling that, despite these developments, competitiveness effects were less important than the drag coming from market structure.3 Our exports are concentrated in slowgrowing advanced economies, particularly the United States, rather than fast-growing emerging markets. This concentration reduced the annual average rate of export growth by D. de Munnik, J. Jacob, and W. Sze, “The Evolution of Canada’s Global Export Market Share,” Bank of Canada Working Paper, forthcoming. BIS central bankers’ speeches around 3.3 percentage points between 2000 and 2007 (Chart 5, Table 1). By comparison, the drag from competitiveness effects was about 2.5 percentage points. In short, our underperformance prior to the crisis was more a reflection of who we traded with than how effectively we did it. This is even more the case since the onset of the Great Recession. Canadian export growth has continued to lag the global average by about 5 percentage points annually. Competitiveness effects have remained relatively stable. The combination of overexposure to the U.S. market and underexposure to faster-growing emerging markets is almost entirely responsible for Canada’s further loss in world market share over the last several years. It does not have to be this way. Many advanced countries have been more successful at capitalizing on the immense opportunity that emerging markets in general and China in particular represent. For example, Germany has maintained its market share in manufactured goods by exporting capital goods and autos to China, and more broadly to emerging-market economies. Australia has gained substantial market share in its exports of commodities to fill rising demand from China. Expect these trends to continue The obvious question is whether we can expect these trends to continue. The answer is yes. BIS central bankers’ speeches A new normal for the United States Our reliance on the United States is an issue only if we expect U.S. underperformance relative to both history and the rest of the world to continue. Unfortunately, that is what we must expect as, to a degree, the U.S. economy is not what it used to be. Allow me to explain. The trend in U.S. potential growth – the “speed limit” if you will of the U.S. economy – was already falling in the year leading up to the crisis, reflecting both an aging population and slower productivity growth. In the meantime, emerging markets were increasingly living up to their name, with large productivity increases raising their speed limits. The result was the increasing underperformance of the U.S. economy relative to the rest of the world. The Great Recession has made things worse. History suggests that the output lost following a severe financial crisis is never recovered, implying that the United States will not get back on its old path. Moreover, the post-crisis potential rate of output growth also tends to be slower for some time, in part reflecting less capital investment and more structural unemployment. As a result, even once the U.S. economy recovers its cyclical losses, the Bank estimates that it will remain over $1 trillion smaller in 2015 than we had projected prior to the crisis (Chart 6). Now, it is important not to overstate this. The United States remains the largest economy in the world but, going forward, the game there will be more about taking market share than participating in a rapidly growing market. Emerging-market opportunity Emerging markets represent the greater opportunity for Canadian exporters. Since the recession, these economies have accounted for roughly two-thirds of global economic growth and one-half of the growth in global imports. In a process that can be expected to BIS central bankers’ speeches 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 and representing a fast-rising share of global demand for all types of goods. This is where Canadian businesses must increasingly look for export growth. Commodity prices are expected to remain elevated The expanding urban middle class in emerging economies is having a marked impact on a wide range of commodities. Yet, whether it is travel, housing or protein, consumption levels in major emerging markets are still only fractions of those in advanced economies.4 With convergence a long way off, the demand for commodities can be expected to remain robust. As a result, commodity prices have risen well above their historical averages, and are likely to remain there for some time. Canada is benefiting from this both directly and via spillovers across our economy. Persistent strength of the currency Canada is likely to remain a relatively attractive investment destination, owing to the strength of our financial system, competitive tax system, sound public finances and credible monetary policy. Given this and elevated commodity prices that have raised our terms of trade, a sustainable export strategy cannot rely on expectations of a more favourable exchange rate. 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. BIS central bankers’ speeches How to take advantage To take advantage of these shifting patterns of global demand, our businesses need to refocus, retool and retrain.5 Refocus on developing new markets and new products. While the United States will always loom large in Canadian trade, geography need not be destiny. For many firms, the most attractive option is now to expand into emerging markets. Canada’s aggressive trade strategy promises to enhance these prospects. There are other opportunities. For many firms, there are openings to become part of new, networked supply chains that are being created in response to the demonstrated fragility of single-source, lean alternatives, the proliferation of end products and the volatility of regional demand. Canadian firms could also further exploit the tremendous opportunities in mobile computing and customer-focused applications that capture more of the value in the shift to digital commerce that is occurring across the globe. New markets can also be found at home. It is clear that K-W cannot directly satisfy China’s growing appetite for commodities, but you can and are taking advantage of other areas of the country that do. One out of twelve oil sands manufacturers and suppliers are from this region, and Ontario’s exports to Alberta of mining-related services grew 44 per cent in the last year measured. The opportunity to capture more of the value added in commodity production from energy to agriculture remains a tremendous opportunity for all of Canada. Retool by investing in plant, equipment and ICT (information and communications technology) and developing new processes. The competitiveness imperative to invest in productivity-enhancing M&E (manufacturing and equipment) and ICT is clear, and the conditions to do so have rarely been so favourable. Canadian corporate balance sheets are extremely healthy, with record low leverage and very high levels of liquidity. Businesses are further supported by a well-functioning financial system and extremely supportive financial conditions. Businesses across Canada are stepping up, including here in the K-W region, where there are numerous examples of firms responding to the decline of traditional manufacturing industries, such as autos and clothing, by moving up the value chain. Overall, business investment has rebounded smartly since its dramatic decline in the wake of the Lehman collapse. However, it still has a long way to go. Moreover, it is not merely a question of how much we invest in new tools but also what we do with them. Indicators of how well we use labour and capital to produce output (such as multifactor productivity) have been exceptionally weak for years. We can do better. For example, the brainpower in this region appears well-suited to analyse the “big data” necessary to seize such opportunities as optimizing production processes and mass customization. In an era of persistently elevated resource prices, enhancing operating efficiency, improving resource management and developing products with a more sustainable environmental footprint make commercial and social sense. Moreover, advances in building-energy efficiency, enhanced farm yields and power plant efficiency would pay immediate domestic dividends. However, once again, the real prize may be in emerging markets, which contain an estimated 85 per cent of the resource productivity opportunities in the world.6 For a comprehensive and accessible analysis of Canadian productivity, see R. Martin and J. Milway, Canada: What It Is, What It Can Be (University of Toronto Press: Toronto, forthcoming), which draws on their decadelong analysis of these issues. R. Dobbs, J. Oppenheim, F. Thompson, M. Brinkman and M. Zornes, “Resource Revolution: Meeting the World’s Energy, Materials, Food, and Water Needs, McKinsey Global Institute Report, November, 2011. BIS central bankers’ speeches Innovation is critical to our success and Canada’s record is only average. Today, Canada’s business R&D investment is at the lower end of OECD countries. As highlighted in the Jenkins report, particular attention must be paid to the commercialization of R&D – taking innovative ideas from universities and turning them into commercial successes.7 The symbiosis here in K-W between strong educational institutions and a cluster of innovative technology companies is a model for other parts of the country. Retrain by continuing to invest in our greatest resource – our people. Technology and trade are transforming the workplace. For years, routine tasks have been automated, such as the substitution of robots for assembly-line workers and ATMs for tellers. Now the same is happening to interaction work, which has been the fastest-growing employment category. Disaggregation of tasks, such as professional services, to separate out the routine components can lead to outsourcing and job displacement.8 The need to improve skills across the spectrum of work has never been greater. With worldclass educational institutions pumping out highly qualified graduates, you are already making an enormous contribution to raising the skill level of the Canadian workforce. Business and governments need to continue to focus on workplace training as the competitiveness of our industries and the very nature of work continue to evolve. The more Canadian businesses refocus, retool and retrain, the more they can take advantage of opportunities in Canada and around the world. Current economic conditions in Canada Let me conclude with some comments on current economic conditions in Canada, which reflect a number of the themes I have discussed. The recoveries in Canada’s major trading partners continue to be dampened by the ongoing need to repair sovereign, bank and household balance sheets. As a consequence, the level of external demand for our products in advanced economies remains weak. That said, in recent months, the considerable external headwinds have abated somewhat. European bank funding and sovereign debt markets have stabilized, global financial conditions have improved and risk aversion has decreased. This creates a window for European authorities to address the deep structural issues in their monetary union. While the European situation is far from resolved, the challenges have moved from the acute to the chronic. The U.S. economy remains on the modest growth path typical of recoveries following financial crises. Given that context, recent data have been encouraging. Monthly employment gains in the past three months have been the fastest in a year. Consumer and business confidence have rebounded. And fundamentals for household spending have improved with higher personal income and household net worth. Although activity in a number of emerging-market economies has slowed, the emerging world remains the engine of global growth. In particular, past tightening of policy and weaker external demand are slowing activity in China to a still-robust pace. Improving global economic conditions have contributed to higher commodity prices, with geopolitical risks adding a further premium on crude oil prices. Innovation Canada: A Call to Action, Review of Federal Support to Research and Development,” Expert Panel Report, October, 2011. J. Manyika, S. Lund, B. Auguste, and S. Ramaswamy, “Help Wanted: The Future of Work in Advanced Economies,” McKinsey Global Institute Discussion Paper, March 2012. BIS central bankers’ speeches Conditions in the Canadian economy have also been somewhat stronger and the degree of slack somewhat smaller than the Bank had expected. Growth has been a bit quicker in recent quarters, reflecting a combination of temporary factors as well as improved confidence and better financial conditions. Although net exports have picked up somewhat due to stronger U.S. activity, their contribution to growth will be limited by a still-weak level of foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. As a consequence, growth remains largely reliant on private domestic demand. Business investment is expected to be an important source of growth going forward, reflecting highly favourable conditions and the competitive need to refocus, retool and retrain. Momentum in household spending remains solid. However, in an environment of more modest growth in employment, wages and net worth, households’ dependence on debt financing remains the biggest domestic risk. As the Bank noted in its March decision, the profile for core and total CPI inflation is somewhat firmer than previously anticipated, reflecting reduced economic slack as well as higher oil prices. Over the next few weeks, the Bank will update its outlook for growth and inflation in Canada to reflect these factors and other developments, such as recent federal and provincial budgets. As always, this analysis will inform our monetary policy decisions. The Bank will take whatever action is appropriate to achieve the 2 per cent CPI inflation target over the medium term. This is our contribution to ensuring that Canadians can save and invest with confidence. Over the next few years, Canadian businesses will also have to analyse and act. Their decisions to refocus, retool and retrain will do much to determine how rapidly our prosperity grows in the decades ahead. For Canada to grow in the future as it has in the past, businesses will need to draw on similar resourcefulness that the membership of the K-W Chamber has demonstrated over the years. BIS central bankers’ speeches BIS central bankers’ speeches
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Remarks by Mr Jean Boivin, Deputy Governor of the Bank of Canada, presented to the Economic Club of Canada, Toronto, Ontario, 4 April 2012.
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Jean Boivin: Aging gracefully – Canada’s inevitable demographic shift Remarks by Mr Jean Boivin, Deputy Governor of the Bank of Canada, presented to the Economic Club of Canada, Toronto, Ontario, 4 April 2012. * * * Thank you for having me here today. I’m here to talk about something inevitable and mostly dreaded: aging. Every day – if we’re lucky – we get older. But don’t worry, I’m not here to give a motivational talk about personal growth and aging – I’m not the most qualified person to do that. What I would like to discuss is the aging of Canada’s population as a whole and its implications. And in this case, luck has nothing to do with it. One of our gracefully aging Canadians, Leonard Cohen, once wrote, “Reality is one of the possibilities I cannot afford to ignore.” I won’t get into whether “reality” is just a “possibility” – I’m an economist, not a philosopher – but there is no doubt aging is a reality, and it is one we simply cannot afford to ignore. Whether we like it or not, we are getting older as a society. The prospect of an aging population has been with us for a long time. Long before I was born, the United Nations published the first of several studies on the issue. 1 At the Bank of Canada, the importance of addressing this challenge has been raised many times and in many places. 2 Not only has this prospect been with us for a long time, but it has also been entirely predictable (Chart 1). Aging in Canada has evolved almost exactly as projected 10 years ago and the outlook remains the same. Let me tell you: when compared with the typical economic phenomena that central banks work with, forecasting aging is a piece of cake. What is much less easy to predict, however, is how society will adjust to aging, and the flexibility it will have to do so. Ten years ago, we didn’t know the world would be facing the greatest financial crisis since the Great Depression which has resulted in vast amounts of lost wealth and higher debt levels for governments and individuals. What that means is that today in advanced economies we still face the problem of an aging population – it has not gone away – but with less room to manoeuvre. This is a situation that should give us cause for more than a few worry lines. But no matter how we adjust, one thing is for sure: aging will change the Canadian economic landscape. We have started to see the impact of this process and it will intensify. This will The topic of population aging in developed countries was brought to the attention of a broad audience by the first of many UN studies in 1956 in “The Aging of Populations and its Economic and Social Implications, Population Studies”, No. 26 (United Nations publication, Sales No. 1956. XIII.6). By 1982, the global relevance of the topic was acknowledged in the First World Assembly on Aging in Vienna, and a call for action was put forward. See David Dodge, “Past Adjustments and Future Trends in the Canadian Economy,” (remarks to the London Chamber of Commerce, London, Ontario, 8 December 2003); “Canada’s Competitiveness: The Importance of Investing in Skills” (remarks to the Humber College Institute of Technology & Advanced Learning, Toronto, Ontario, 30 March 2005); “Demographics, Labour Input, and Economic Potential: Implications for Monetary Policy” (remarks to the St. John’s Board of Trade, St. John’s, Newfoundland and Labrador, 13 June 2007). See also Mark Carney, “The Coming Thaw” (remarks to the Winnipeg Chamber of Commerce, Winnipeg, Manitoba, 4 February 2010); “The Virtue of Productivity in a Wicked World” (remarks to the Ottawa Economics Association, Ottawa, Ontario, 24 March 2010); “Growth in the Age of Deleveraging” (remarks to the Empire Club of Canada, Toronto, Ontario, 12 December 2011). BIS central bankers’ speeches have broad implications, including for monetary policy. This is what I would like to discuss today. Current demographic situation Let’s first quickly remind ourselves of the facts. When we think of population aging, we immediately think of the baby boomers who are just starting to retire. Canada did indeed have the most sizable baby boom among the G-7 countries, and it is certainly an important demographic phenomenon (Chart 2). But as someone who has come of age in the shadow of the baby boom, let me say this: baby boomers, this is not just about you. Although the post-WWII baby boom is speeding up the transition toward an older population, it is neither the cause nor the main driver. The aging of Canada’s population would have occurred, with or without the baby boom. There are two much more important and persistent drivers at play: first, a decrease in total fertility below the replacement rate of 2.1 children per woman and second, a considerable increase in life expectancy. We can trace the beginning of this shift to northern European countries as far back as the 1870s, where fertility rates have been on a downward trend (Chart 3). In Canada, total fertility rates peaked in the early 1960s, during the baby boom, and then plummeted to where they are today. For 40 years now Canada’s total fertility rate has been below 2.1. At roughly the same time in the 1870s that fertility rates dropped, we saw large declines in mortality, mostly of children. As the once commonplace death of a child is thankfully far in the past, at least in advanced economies, the big change we see now is in the significant increase in life expectancy. Consider this: Canadians born in 2000 could expect to live almost three decades longer than those born in 1900 (Chart 4). More people living longer swells the ranks of the non-working population and changes the ratio of older non-working people relative to working-age people. This ratio is commonly referred to as the “old-age dependency ratio.” Looking at the expected evolution of this ratio, an important conclusion is that the aging of the population has begun and it will soon accelerate. The crunch will be unprecedented in history, both in scope and size (Chart 5). In Canada, by 2031 about one in four people will be over 65. 3 As for those over 80, they are the fastest-growing segment of the older population, a group that, relative to 2000, will have nearly doubled by 2026 and quadrupled by 2051. 4 Canada is not the only nation getting older (Chart 6). Population aging is common across advanced economies. All G-7 countries have seen a drop in the Total Fertility Rate and an increase in life expectancy. Canada’s situation is more favourable than that of other G-7 countries such as Japan. We are not aging as early or as fast. Two reasons for this difference are that more Canadian women are in the labour force and we have much higher rates of immigration. 5 F.T. Denton, C.H. Feaver, and B.G. Spencer 2005 as cited by Charles M. Beach in “Canada’s Aging Workforce: Participation, Productivity, and Living Standards,” in A Festschrift in Honour of David Dodge, Bank of Canada, November 2008. “The Demographic Time Bomb: Mitigating the Effects of Demographic Change in Canada.” Report of the Standing Senate Committee on Banking, Trade and Commerce, June 2006. Charles M. Beach, “Canada’s Aging Workforce: Participation, Productivity, and Living Standards,” in A Festschrift in Honour of David Dodge, Bank of Canada, November 2008. BIS central bankers’ speeches The fact that aging is a phenomenon shared by advanced economies is no coincidence. Historically, increased life expectancy and low fertility rates are common to societies with higher standards of living. With a higher standard of living we are more likely to get old. Babies don’t die at birth; they may grow to become octogenarians. This is a cause for celebration, not dismay. Population aging is in large part the result of positive forces as economies develop. The task ahead is to figure out how to make the right adjustments. Ignoring reality So what are the economic consequences of aging? Ultimately, if we ignore the reality of aging and make no adjustments, the consequence will be a lower standard of living. An aging population implies a smaller proportion of working people relative to people not working. That means a pie growing more slowly than the number of eaters – less for everyone. The stakes are high: Bank of Canada calculations show that in the absence of any adjustments, the average incomes of Canadians could be as much as 20 per cent lower in 20 years than they would otherwise be without aging (Chart 7). Such numbers need to be interpreted carefully and let me be clear: this is not a forecast of what is likely to happen. Although they are hard to predict, there will be adjustments that will mitigate the impact of aging. But this number does show that the implications of aging, by itself, are major and the size of the needed adjustments is considerable. As Canadians age, several pressure points will emerge, singly or in conjunction. The consequences will affect the labour market, private and public bottom lines, the structure of the economy, and income inequality. Let me say a few words about these various pressure points. Aging will put pressure on the labour market. As workers retire and there are fewer people to replace them, there will be upward pressure on wages and adjustments on the composition and the nature of the labour force. For firms, attracting talent, while retaining relevant expertise and institutional knowledge, will be more challenging. The Bank of Canada is no exception, and we compete with many of you to recruit the brightest and the best talent. Aging will put pressure on public finances. A smaller fraction of the population will be working and contributing to public revenues, and more people will be depending on their pensions, either public or private, to maintain their standard of living. Further, citizens require increased health care as they grow older, which will also place pressure on the public purse – fewer resources, more demand (Chart 8). Aging will put pressure on private savings. As the proportion of prime-age savers – age 35 to retirement – declines, this will act as a drag on aggregate savings. Moreover, at the individual level, as Canadians live longer in retirement, they will need to change their savings behaviour and to plan over a longer horizon. The high levels of household debt in Canada make the need for such adjustment even more crucial (Chart 9). Aging will also put pressure on the redistribution of wealth across generations. The less we adjust, the larger the burden the next generations will inherit. Accepting reality These pressure points show that change is upon us no matter what we do. To avoid drastic declines in our living standards or shifting too great a burden on the next generations, there are only three options: more work, greater productivity and higher savings. These options will require action from all Canadians. Policy measures can help foster the needed adjustments BIS central bankers’ speeches and this is the objective of some of the measures put forward, for instance, in last week’s federal budget. Since the problem starts with shrinking labour input, a natural place to look is for ways to counteract this decline. There are various options to contemplate. Individuals might decide to stay longer in the work force. This can be facilitated by the fact that Canadians are, on average, healthier than previous generations and today more jobs are knowledge-based. Businesses could offer more flexible working arrangements. Technological change and corporate policies can provide more flexibility for workers, such as teleworking, part-time work, job-sharing, off-site consulting, and other innovations. Another option is immigration, and it is very important to Canada: without it, the population would be expected to shrink over the next 50 years (Chart 10). A key challenge with immigration is to remove the various barriers that keep educated and skilled immigrants from contributing to their full potential. But making the best of the aging process is not only a question of fighting labour shortages, it is also a question of finding ways to do more with fewer workers. Investing in capital is one way to do it: with more machinery and equipment, workers can produce more. Strategic investments can lead to innovation and technological progress that make machines and processes more efficient. Better organization can also play an important role. Firms can use the pool of workers more effectively, and workers and managers can improve their performance through education and training. With populations aging in advanced economies, the relative importance of various economies will change and so will the tastes and needs of an aging population. This will require structural adjustments. Successful businesses will look ahead and see where new markets are developing – both at home and abroad – and where gaps are in terms of products and services. 6 Workers will need to adapt to the changing demands for their skills and gain the qualifications necessary to thrive in a new economy. Ultimately, this is about being more productive – also a recurring theme for the Bank of Canada and others. 7 Finding the elusive cure for Canada’s lagging productivity remains a pressing concern, and the demographic challenge makes it even more imperative. To put things in perspective, as much as two-thirds of the average income loss due to the absence of adjustment to aging – the 20 per cent figure I mentioned earlier – could be regained if productivity grew at a rate close to its average over the past 50 years, instead of at the anaemic rate experienced over the past decade. But investing more, to increase capital or to boost productivity, will require other adjustments as well. More resources will need to be put aside to finance these investments. As individuals and families understand the challenges of aging, they may realize how much more savings they will need to maintain their standard of living throughout retirement. In this regard, improving financial literacy can help promote these adjustments, through a better understanding of financial products and the important role of private savings. It will also be crucial to ensure that pension funds, and the financial system more generally, channel these savings into long-term productive investments. Mark Carney, “Exporting in a Post-Crisis World” (speech to the Greater Kitchener-Waterloo Chamber of Commerce, Waterloo, Ontario, 2 April 2012). For a literature review, see B. Fay and R. Dion, “Understanding Productivity: A Review of Recent Technical Research,” Discussion Paper No. 2008-3, Bank of Canada, 2008.See also M. Carney, “The Virtue of Productivity in a Wicked World” (speech to the Ottawa Economics Association, Ottawa, Ontario, 24 March 2010). See also T. Macklem, “Canada’s Competitive Imperative: Investing in Productivity Gains” (speech to Productivity Alberta, Edmonton, Alberta, 1 February 2011). BIS central bankers’ speeches Some of the adjustments will happen naturally. For instance, shrinking labour input will put upward pressure on wages. Higher wages might provide greater incentives for workers to acquire more education and training. Scarcity of labour and lower costs of capital might offer greater incentives for firms to invest and increase productivity. But none of these challenges will be resolved magically by themselves and something will definitely have to give. Implications for monetary policy It is not the Bank of Canada’s role to determine the extent of adjustments needed from each of us – government or private sector, households or businesses, current or future generations. This depends on our values and goals as a society and this is something that Canadians will have to decide on collectively. So what is the Bank’s role here? Monetary policy cannot, of course, directly influence the aging process or its impact on the Canadian economy. But monetary policy can facilitate the necessary adjustments to aging by contributing to a stable and predictable economic and financial environment. In this regard, one of the Bank of Canada’s main contributions is to deliver low, stable and predictable inflation. This promotes growth, mitigates economic cycles and protects the purchasing power of money. It makes it easier for consumers and businesses to manage their finances and to plan ahead. The stability of the financial system is also essential. As the painful lessons of other countries have demonstrated in recent years, price stability is no guarantee of financial stability, and a financial crisis can significantly hamper a country’s ability to deal with challenges such as an aging population. This is why the Bank is contributing to and supporting the G-20 agenda for financial reform. This is also why Canadian authorities, including the Bank, will need to remain as vigilant as they have been in the past to the possibility of financial imbalances developing. To maintain price stability and support the adjustments to aging across the economy over time, the Bank itself will also have to adjust. That is because demographics affect the way in which we seek to achieve our objectives, most directly in influencing the potential of the economy – the level of activity at which the economy can operate without creating inflationary pressures. Monetary policy cannot influence this long-run speed limit. It must obey it. This is why the Bank needs to assess, through analysis and research, the implication of aging on potential output. 8 This task is complicated by the fact that it depends not only on the evolution of labour input, but also on how the economy adjusts to the demographic changes, for instance through productivity. Our assessment on the evolution of potential output is reflected in our outlook for the Canadian economy. 9 According to our latest estimate, from the October 2011 Monetary Policy Report, the growth of potential output in 2014 is expected to be 2.2 per cent. Without the decline in the working age population it would be 0.2 percentage points higher. Aging is projected to continue to subtract from potential output growth until the end of the current decade (Chart 11). See R. Barnett, “Trend Labour Supply in Canada: Implications of Demographic Shifts and the Increasing Labour Force Attachment of Women,” Bank of Canada Review (Summer 2007). See also Alexander Ueberfeldt, “Canada’s retirement system: Prepared for an aging population?” Bank of Canada, 2009. See the Bank of Canada’s October 2011 Monetary Policy Report, page 19. BIS central bankers’ speeches Aging is thus already one of many factors influencing the setting of monetary policy. As Governor Carney said this week, taking all relevant factors into account, including recent developments, the Bank will take whatever action is appropriate to achieve the 2 per cent CPI inflation target over the medium term. This is our contribution to ensuring that Canadians can save and invest with confidence. But the implications of aging for monetary policy go beyond the horizon that is relevant for the current setting of monetary policy. As I hope I have made clear today, the most important demographic changes are yet to come and these will bring about sweeping adjustments. Eventually, the landscape in which monetary policy is operating will be altered. For instance, the aging population in advanced economies may in time have implications for the level of global interest rates. Taken in isolation, the scarcity of labour relative to capital would lead to higher wages and lower returns on capital, which could eventually contribute to persistently lower interest rates. If that materialized, it would lead to a higher risk of approaching the zero lower bound on nominal interest rates with all of its implications. 10 But many forces affect global interest rates and adjustments to aging, such as improved productivity, would offset these downward pressures on global interest rates. Also, household saving and consumption behaviours will change and so will expenditure patterns. This could alter the way in which monetary policy affects the economy. Conclusion Let me conclude. Canada made it through the financial crisis better than most G-7 countries. It was a shock from outside our borders that was sudden and unexpected. The future can deliver surprises. But the challenges of demographic change will not be a surprise. We’ve known about them for a long time. They are coming our way. As our society ages, we can either accept a lower standard of living or we can be proactive and adjust. The stakes are high and we cannot afford to ignore them. There is no free lunch; somebody will have to pick up the tab. The least we can do is accept this fact and ensure that the bill remains small and that the burden is shared fairly. The decisions we all make are largely influenced by what we think the future will bring, if we are aware and pay attention to it. Acceptance of the demographic challenges before us should lead the way to proper planning. Part of aging gracefully is accepting the inevitable and making the best of it. Getting older should be about getting better – it’s about being wiser and more thoughtful about the future and what lies ahead. There are various options available to individuals and families, businesses, and policy-makers to ensure that we continue to improve our standard of living. Whatever we decide, our reality will change. That is why we, at the Bank of Canada, will continue to pay close attention to how this situation evolves. Thank you very much. Mark Carney, “Living with Low for Long” (speech to the Economic Club of Canada, Toronto, Ontario,13 December 2010) and Alexander Ueberfeldt, “Canada’s retirement system: Prepared for an aging population?” Bank of Canada, 2009. 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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Opening statement by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the press conference following the release of the Monetary Policy Report, Ottawa, 18 April 2012.
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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, 18 April 2012. * * * 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. The profile for global economic growth has improved since the Bank released its January MPR. Europe is expected to emerge slowly from recession in the second half of 2012, although the risks around this outlook remain high. The profile for U.S. growth is slightly stronger. This reflects the balance of somewhat improved labour markets, financial conditions and confidence on the one hand, and emerging fiscal consolidation and ongoing household deleveraging on the other. Economic activity in emerging-market economies is expected to moderate to a stillrobust pace over the projection horizon, supported by an easing of macroeconomic policies. Commodity prices remain elevated owing to improved global economic prospects, supply disruptions and geopolitical risks. In particular, the international price of oil has risen further and is now considerably higher than that received by Canadian producers. If sustained, these oil price developments could dampen the improvement in economic momentum. Overall, economic momentum in Canada is slightly firmer than the Bank had expected in January. The external headwinds facing Canada have abated somewhat, with the U.S. recovery more resilient and financial conditions more supportive than previously anticipated. As a result, business and household confidence are improving faster than forecast. The Bank projects that private domestic demand will account for almost all of Canada’s economic growth over the projection horizon. Household spending is expected to remain high relative to GDP as households add to their debt burden, which remains the biggest domestic risk. Business investment is projected to remain robust, reflecting solid balance sheets, very favourable credit conditions, continuing strong terms of trade and heightened competitive pressures. The contribution of government spending to growth is expected to be quite modest over the projection horizon, in line with recent federal and provincial budgets. The recovery in net exports is likely to remain weak in light of modest external demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. The Bank projects that the economy will grow by 2.4 per cent in both 2012 and 2013 before moderating to 2.2 per cent in 2014. The degree of economic slack has been somewhat smaller than anticipated, and the economy is now expected to return to full capacity in the first half of 2013. As a result of this reduced slack and higher gasoline prices, the profile for inflation is expected to be somewhat firmer. After moderating this quarter, both total and core inflation are expected to be around 2 per cent over the balance of the projection horizon as the economy reaches its production potential, the growth of labour compensation remains moderate, and inflation expectations stay well-anchored. BIS central bankers’ speeches Despite recent improvements to the outlook for the global and Canadian economies, risks remain elevated. The three main upside risks to inflation in Canada relate to the possibility of higherthan-expected oil prices, stronger-than-expected growth in the U.S. economy and stronger momentum in Canadian household spending. The two main downside risks to inflation in Canada relate to a reintensification of sovereign debt and banking concerns in Europe, 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 period. Reflecting all of these factors, the Bank yesterday maintained the target for the overnight rate at 1 per cent. In light of the reduced slack in the economy and firmer underlying inflation, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term. The timing and degree of any such withdrawal will be weighed carefully against domestic and global economic developments. With that, Tiff and I would be pleased to take your questions. BIS central bankers’ speeches
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Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Chartered Institute of Logistics and Transport North America, Ottawa, Ontario, 30 April 2012.
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Timothy Lane: Transport and logistics – connecting Canada to the global economy Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Chartered Institute of Logistics and Transport North America, Ottawa, Ontario, 30 April 2012. * * * Good morning. It’s a pleasure to be with you as you reflect on the challenges facing the North American transport and logistics industries in the current global economic environment. Your industries are inextricably linked with the wider economy: they enable other economic activity by connecting producers with their suppliers and markets elsewhere in Canada and around the world. Throughout Canadian history, transport has played a critical role in the development of our nation, knitting together the economy over vast distances and forging strong trade links around the world. So as I speak to you today, I would first like to think back to the last great wave of globalization, a century ago. One of the giants of that time was Charles Melville Hays, whom Sir Wilfrid Laurier described as “the greatest railroad genius in Canada.” Hays, President of the Grand Trunk Railway, had a vision: to build a second transcontinental rail line across Canada with Prince Rupert as its western terminus, establishing a gateway to the Pacific. Hays did not live to see his vision realized. One hundred years ago this month, after carefully seeing his wife and daughter onto a lifeboat and bidding them goodbye, Hays went down along with more than 1,500 other souls on the Titanic. Canada lost Hays’s drive and leadership as well as the financing he had just secured in London to make his plans for Prince Rupert a reality. But his broader vision of building transport to make connections with expanding markets— including those beyond our Pacific shores – remains relevant today as we consider the future of transport and logistics in the Canadian economy. It is also a reminder of the long-range thinking and strong leadership that are needed to build for that future. For the past few decades, globalization has been a central force shaping transport and logistics – and indeed, Canada’s economy as a whole. Canada is taking part in a worldwide transformation that has lifted hundreds of millions of people out of poverty and created the potential for millions more to share this destiny. Never in history has economic integration involved so many people, such a variety of goods, and so much capital. Between 1980 and 2005, merchandise exports grew to 20 per cent of global GDP, more than twice the level reached at the height of that last great wave of globalization a century ago.1 Advances in transport and supply chain management have played, and will continue to play, a central role in enabling that expansion. Today I would like to focus on two main themes. First, I would like to talk about economic prospects for Canada in the current global environment. Second, I would like to touch on the longer-term implications of that global environment for Canada’s trade and transport. The crisis, trade and transportation During the past five years, your industries have faced serious challenges. As a result of the global financial crisis and the Great Recession that followed, Canadian GDP declined by 4½ M. Carney, “Rebalancing the Global Economy” (speech to the International Economic Forum of the Americas Conference of Montreal, 11 June 2009). BIS central bankers’ speeches per cent but our exports plunged more than 16 per cent. As a result, transport experienced a 7 per cent drop in activity from peak to trough (Chart 1). For example, there was a severe decline in cargo volumes through ports and marine terminals: a drop of 20 per cent in domestic cargo and a cumulative drop of 10 per cent in international cargo in 2008–09. Canada’s economy is now in an expansion phase: economic activity and employment passed their pre-crisis levels in the fall of 2010 and have continued to grow since then. Canada’s transport industry has shared in this recovery. However, a major challenge – both to transport and to the economy as a whole – has come from exports, which are experiencing their weakest recovery since World War II (Chart 2). BIS central bankers’ speeches The sluggish recovery of Canada’s exports, in turn, reflects a combination of current macroeconomic conditions and longer-term trends. First, it reflects the weakness of the recovery in other advanced countries – notably the United States, still by far our largest trading partner. But Canada’s share of global exports has been declining since the turn of the millennium as we have lost competitiveness and market share to China and other export economies (Chart 3). Canada’s diminishing competitiveness is the result of disappointing productivity growth together with the considerable strengthening of the Canadian dollar over this period. The shift of global growth from advanced economies to emerging economies is tectonic in its scope. While it began a few decades ago – stemming from the economic transformation taking place in China and other emerging-market economies – it has become even more pronounced as growth in the United States and other advanced economies has been dampened in the wake of the financial crisis. Since the recession, emerging-market economies have accounted for two-thirds of global economic growth – up from just one-third at the turn of the millennium. Emerging market economies also account for one-half of the growth in global imports. Compare this with the United States where the economy is now well below its pre-crisis path and is likely to remain so even once the economy recovers its cyclical losses2 (Chart 4). Clearly, exporters need to refocus their efforts to the fast-growing economies. M. Carney, “Exporting in a Post-Crisis World” (speech to the Greater Kitchener- Waterloo Chamber of Commerce, Waterloo, Ontario, 2 April 2012). BIS central bankers’ speeches Current outlook: where we are today The global economy continues to face significant challenges. In the major advanced economies, especially the United States and Europe, deleveraging by households and financial institutions and fiscal consolidation continue to weigh on growth. In the United States, the protracted dislocation of the housing market has been a drag on the recovery, despite some recent improvement. The debt crisis in the euro area, which intensified late last year, triggered a recession there and has had negative spillovers to many other countries, including the United States. In emerging market economies such as China, growth is moderating from the rapid pace of recent years, as exports to Europe have fallen off and domestic demand has also cooled. However, economic growth is expected to gain momentum over 2013–14, as exports to advanced economies recover. Despite these challenges, the profile for global economic growth has improved since the beginning of this year.3 In particular, economic conditions in the United States have improved, with employment gains and better consumer and business confidence. The euro area, however, is still in recession, and is projected to show only a modest recovery later this year, although the risks around this projection are high. Overall, global economic growth is now projected to moderate in 2012 to 3.2 per cent and to recover to 3.4 per cent in 2013 and 3.8 per cent in 2014. Here in Canada, economic momentum is slightly firmer than a few months ago. Since Canada’s economic growth has also turned out stronger than expected in recent quarters, we estimate that there is now less slack in the Canadian economy than previously anticipated (Chart 5). The discussion in this section is based on the Bank of Canada’s April 2012 Monetary Policy Report. BIS central bankers’ speeches In addition, growth is expected to continue in the period ahead – at 2.4 per cent in 2012 and 2013, easing to 2.2 per cent in 2014. These growth rates may seem relatively modest, but over the 2012 to 2013 period, they are somewhat above the rate at which the potential of the economy is expanding, estimated at 2 per cent in 2012 and 2.1 per cent in 2013. As a result, we expect the Canadian economy to return to full capacity by early next year (Chart 6). BIS central bankers’ speeches Most of the growth in the period ahead is expected to come from private domestic demand. In particular, that growth relies on continued spending by Canadian households on consumption and housing. It also reflects a continued strong rise in investment spending as Canadian firms seek to expand, replace, and modernize their capacity. On the other hand, we are still seeing weak growth in Canada’s net exports. That in turn reflects factors I mentioned earlier: notably the protracted recovery of demand in the United States, Canada’s major trading partner, and Canada’s weak competitiveness. The Bank forecasts that Canada’s exports will regain their pre-recession peak only at the end of 2013. In contrast, the level of imports has already regained its pre-recession peak. This divergence has contributed to a decline in Canada’s current account balance, which has dropped from a pre-recession surplus to a deficit of approximately 2 per cent of GDP – a trend that is projected to persist (Chart 7). Oil prices are one important factor underlying the economic outlook for Canada – and here is a story in which transport has been playing an important role. Canada as a whole usually benefits when oil prices rise. As a net oil exporter, Canada gains from higher incomes in the industry, higher production and investment and the resulting spillovers to other parts of the economy. Those benefits typically outweigh the effects of more expensive gasoline on the cost of living and the effects on production costs. In recent months, this balance of costs and benefits has shifted because of an unprecedented spread between the price of oil that Canada imports and the price of oil that Canada exports – a spread that peaked at about $50 a barrel earlier this year (Chart 8). There are many reasons for this, some of which are temporary. Growing global demand – especially from emerging-market economies – together with supply disruptions and rising political tensions in the Middle East have driven up the world price of oil that Canada imports. At the same time, shale-oil development in the United States, together with other factors, has led to ample supply at Cushing, Oklahoma, where the North American price for West Texas Intermediate (WTI) is set. The Canadian price for Western Canada Select (WCS) has been driven down further by outages in some pipelines and refineries equipped to handle Canadian oil. Underlying these divergences is a basic fact: the transport system determines BIS central bankers’ speeches the ability of Canadian producers to move goods such as oil to those markets where it commands a higher price, and thus to benefit from participating in a global market. The various aspects of the macroeconomic outlook I have been describing come together in the outlook for inflation. Because there is less slack in the economy and gasoline prices are also higher, the profile for inflation is expected to be somewhat firmer than anticipated by the Bank in January. Both overall inflation and underlying inflation are expected to remain close to 2 per cent through to the end of 2014 (Chart 9). BIS central bankers’ speeches Reflecting all of these factors, the Bank has decided to maintain the target for the overnight rate at 1 per cent. In light of the reduced slack in the economy and firmer underlying inflation, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term. The timing and degree of any such withdrawal will be weighed carefully against domestic and global economic developments. Opportunities for transport and logistics I would now like to touch on the longer-term trends in the global economy and what they mean for your industries. In 1902, Charles Melville Hays saw opportunity in the waves of immigrants pouring into the West. Prairie agriculture was expanding rapidly. Mining and forestry camps were springing up in the North. The rate of growth was fast and it was clear that success depended on moving people and goods across this vast land quickly and efficiently. Today, we can look across the Pacific Ocean where Asia is urbanizing at a breakneck pace. China and India are housing the equivalent of the entire population of Canada every 18 months. A massive middle class is being formed, growing by 70 million people each year – people who represent a rapidly-rising share of global demand for all types of goods. By shifting trade from slow-growing economies to fast-growing ones, Canada can participate more fully in the global economic transformation that we are living through. That’s where the strongest potential import markets are. The opportunities are vast. In view of the scope of these changes and the speed with which they are taking place, it will be critical to anticipate change and make the long-term investments needed to prepare for it. Transport and logistics will be an integral part of all of these efforts. I started by mentioning the critical role transportation played historically, in bonding Canada together as a country spanning great distances. It must continue to play that role now and in the future, creating and supporting an integral, efficient Canadian economy. Our domestic transport systems must evolve to make it easier to move goods within Canada. We will need to pick up our game domestically to remain competitive in a challenging global environment. The forces of globalization together with advances in technology necessarily drive important innovations in logistics activities, which have become more global, complex, and sophisticated. To an increasing extent, Canadian businesses are part of supply chains that frequently cross and re-cross national boundaries. Such activities are also interconnected across various sectors, such as natural resources, manufacturing and services.4 Through these developments, globalization has progressively become a more pervasive feature of the production process. The increasing complexity of supply chains also means that Canadian businesses can benefit from trade with India and China, not only by selling their final products there, but by supplying and adding value to firms here at home that do. For transport and logistics, opportunities to contribute abound and these will change as technology advances and businesses invest in plant, equipment and information and communication technologies, establish new facilities and develop new processes. These areas are now so strongly knowledge-based that developing the requisite skills and technologies is critical to success. This is why all sectors of the economy must continue to invest in Canada’s greatest resource – our people. Industry Canada, “Global Business Strategy and Innovation: A Canadian Logistics Perspective” (2011). BIS central bankers’ speeches Conclusion As I said at the outset, the transport industry was of fundamental importance in building Canada and connecting it with the world beyond. So, too, is your sector vital to the re-building of Canada’s economy in the post-crisis world. Your institute provides scope to introduce state-of-the art analytical tools to shape the transport and logistics of tomorrow. Conferences such as this one provide opportunities for professionals from your industries to discuss and explore options for the future. Trade and transport have been integral to the nature of Canada, long before the arrival of Europeans and after. It will be forever thus, so I encourage you to think big and bold and continue to guide us into the future. Thank you very much. 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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Mortgage Brokers Association of British Columbia, Vancouver, British Columbia, 7 May 2012.
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John Murray: Monetary policy decision-making at the Bank of Canada Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Mortgage Brokers Association of British Columbia, Vancouver, British Columbia, 7 May 2012. * * * Introduction I would like to thank the Mortgage Brokers Association of British Columbia for inviting me to speak to you this afternoon. The title of your conference is intriguing. F. Scott Fitzgerald’s novel, The Great Gatsby, was set in the Roaring Twenties, a period of notable advances coupled with economic excess – and followed by the devastation of the Great Depression. I am not sure what the conference organizers had in mind when they picked the theme for today’s events, but perhaps they wanted to draw attention to the parallels between this earlier era and recent events. In the past 12 years, we have witnessed a period of phenomenal growth and prosperity in the global economy, followed by a deep and synchronous financial crisis in which we nearly repeated the experience of the 1930s. Canada weathered the financial crisis that erupted in 2007?08 better than most of its peers, thanks in part to the healthy condition of its banks, prudent regulation of the financial industry and the country’s strong fiscal position, which allowed the government to implement aggressive countercyclical measures. The Bank of Canada’s monetary policy, guided by the inflation-targeting framework put in place over 20 years ago, also played a critical role in Canada’s performance through the crisis and recovery. It provided significant and timely monetary policy stimulus and, through its hard-earned credibility, helped to anchor household and business confidence in a turbulent time. My subject today is monetary policy decision-making at the Bank of Canada, and my presentation will cover three related topics that I hope you will find interesting and useful, given the important role you play in Canada’s financial industry.1 The first topic is how our monetary policy decision-making process is organized. Something that sounds rather simple in theory is quite complex in practice. The second topic involves the information that is collected and interpreted as part of this process. Monetary policy making, as you shall see, is very information intensive. The third and final part of my presentation focuses on three popular misconceptions about monetary policy that I would like to correct. A short primer on monetary policy Before jumping into a description of the decision-making process, however, it will probably be helpful to say a few words about monetary policy itself, by way of background. As I mentioned earlier, at a conceptual level everything seems relatively simple. Monetary policy in Canada has one objective – achieving and maintaining a low, stable and predictable level of inflation. This objective was formalized in 1991 in an inflation-control agreement between the federal government and the Bank. It identifies a specific target for the rate of This presentation updates and extends T. Macklem, “Information and Analysis for Monetary Policy: Coming to a Decision,” Bank of Canada Review (Summer 2002):11–18. BIS central bankers’ speeches inflation – the midpoint of an inflation-control range – as well as the price index that is to be used to measure inflation. Since 1995, the target level for the inflation rate has been 2 per cent (within a control range of 1 to 3 per cent), as measured by the 12-month rate of change of the total consumer price index (CPI). This may seem like a rather narrow objective – a topic that we will return to later in the presentation – but experience has shown that this is the best contribution that the Bank can make to the economic well-being of Canadians. The greater certainty that it provides with regard to the future path of prices allows households and businesses to make more informed spending and investment decisions, and minimizes the inequity associated with unexpected movements in prices. Keeping inflation low, stable and predictable is a means to an end, not an end in itself. Under normal circumstances, this single objective is pursued using a single policy instrument or tool – changes to the overnight rate of interest.2 The overnight rate is set by the Bank of Canada and determines the rates at which banks and other selected agents are able to borrow and lend at the shortest end of the yield curve. But the story does not end there. Movements in the overnight rate set in train a number of other changes throughout the economy that ultimately affect the rate of inflation. The transmission mechanism This monetary policy transmission mechanism can be described as follows (Figure 1). Changes in the overnight interest rate influence the interest rates that the market sets on securities further out the yield curve and with different risk and liquidity characteristics (for example, mortgage rates). They also influence the exchange rate – the external value of the Canadian dollar. Movements in these asset prices, in turn, affect aggregate demand in the Canadian economy by influencing the spending and investment decisions of both Canadians and foreigners. If strong aggregate demand pressures appeared likely to push output above the economy’s capacity limits and lift inflation above the 2 per cent target, the Bank would respond by raising the overnight rate. This would put upward pressure on other interest rates and the exchange rate, other things constant, dampening aggregate demand, eliminating the gap between actual and potential output, and stabilizing inflation to the 2 per cent target. The process would be reversed, of course, if demand were too weak and inflation seemed likely to fall below 2 per cent. The overnight rate would be reduced, boosting aggregate demand, narrowing the excess supply gap and lifting inflation. It is important to note that the Bank takes a symmetric approach to the pursuit of its monetary policy objective, and is as concerned about undershooting the 2 per cent target as overshooting it. Keeping actual output at or near potential is the only way inflation can be maintained at a low, stable and predictable level. Establishing an explicit inflation target and consistently achieving it helps to build credibility, anchor the inflation expectations of businesses and households, and make monetary policy more effective. An explicit inflation target also provides a direct means by which the Bank’s performance can be judged, thereby improving accountability. In exceptional circumstances, central banks have a number of other, unconventional, monetary policy tools at their disposal. They include quantitative easing, credit easing and conditional commitments concerning the path of future interest rates. These tools have been used by a number of central banks in the past four years as a means of providing additional monetary policy stimulus once the overnight interest rate approached zero and hit its effective lower bound. For more information, see the appendix of the Bank’s April 2009 Monetary Policy Report. BIS central bankers’ speeches This, then, is what the Bank tries to achieve and how it goes about it – through the monetary policy transmission mechanism. Life would be easy if, having achieved the target rate of inflation, we could just leave the overnight rate of interest where it was and let the economy motor on. In reality, of course, this is impossible. The economy is constantly being buffeted by shocks of varying size and duration from both internal and external sources. These shocks are difficult to anticipate (if they were easy to foresee, they wouldn’t be called shocks). Indeed, it is often difficult to identify the nature and potential intensity of a shock until well after it has occurred. Adding to the challenge is the fact that monetary policy operates on the economy with long and variable lags. Adjustments to the policy rate that we make now typically take four to six quarters to have their full effect on economic activity, and six to eight quarters to have their full effect on inflation (essentially two years). Policy, therefore, has to be forward-looking and policy-makers are forced to make their decisions in conditions of considerable uncertainty. So a policy that at first glance appears to be relatively simple and mechanical to execute is in fact very complex and challenging. Fixed Announcement Dates (FADs) Prior to December 2000, the Bank had no fixed or pre-announced schedule for its interest rate decisions. Instead, it stood ready to move whenever action was deemed appropriate. While this may seem sensible and certainly allowed for a great deal of flexibility, experience here and elsewhere showed that it also added uncertainty to what was already a very uncertain operating environment. Businesses, households and market participants never knew if this was going to be the day when the Bank moved rates. It also made planning the forecasting and policy decision-making activities within the Bank challenging. In order to avoid these problems and render the process more predictable, the Bank moved to a system of fixed announcement dates (FADs). It now makes its interest rate decisions on eight pre-announced dates through the year, with a six- to seven-week interval between each one. In exceptional circumstances, however, the Bank reserves the right to change rates on dates that fall outside this schedule. The only two occasions when this has occurred over the past 12 years were on 17 September 2001, following the terrorist attacks on the United States, and on 8 October 2008, as part of a synchronized policy easing with other central banks. The timing of the FADs corresponds to the release of key economic information used for the Bank’s forecasting and monitoring exercises. Four of the FADs occur shortly after the publication of the quarterly National Accounts, which report on Canada’s gross domestic product (GDP) and its various subcomponents. The other four FADs are situated midway between these dates and are also timed to coincide with the availability of important information. The most recent fixed announcement date was 17 April. Who decides? The major players in the FAD process are the Governing Council, the Monetary Policy Review Committee, and the four economics departments at the Bank. Starting from the top, the Governing Council, which is responsible for making the interest rate decision, is comprised of the Governor, the Senior Deputy Governor and four Deputy Governors. The Monetary Policy Review Committee, which plays an important role in the discussions leading up to the decision, includes the Governing Council plus five to six advisers – often supplemented with one or two special advisers – as well as chiefs from the BIS central bankers’ speeches four economics departments, representatives from the Montréal and Toronto regional offices, and certain other senior personnel. The four economics departments are: Canadian Economic Analysis (CEA), International Economic Analysis (INT), Financial Stability (FSD) and Financial Markets (FMD). Most of these titles are self-explanatory, but I’ll note that the Financial Stability Department focuses largely on the activities of Canadian and foreign financial institutions, while the Financial Markets Department concentrates on domestic and foreign financial markets. What do all these people do? For the most part, they share their information, analysis, experience and judgment with members of the Governing Council. The Bank of Canada makes every effort to minimize the inherent uncertainty and risk associated with policy-making by drawing on whatever useful information and insights are available both inside and outside the Bank. The latter includes data series from agencies such as Statistics Canada, current analysis and forecasts from other central banks, governments, international financial institutions and private sector economists, as well as research from academics. All of this is in addition to the contributions of our own staff. The information that flows from these sources is comprehensive and diverse and contributes, at each stage of the process, to the final decision. Let me give you a quick overview of what happens at each stage. A five-stage decision-making process The five key stages of the decision-making process are as follows (Figure 2).3 Stage 1 – the presentation of the staff projection to the Governing Council – occurs three weeks prior to the interest rate decision and has at its centre the Bank’s latest forecasting and policy simulation model, ToTEM2.4 Results from this model are supplemented with information drawn from a number of other sources and alternative models, which either look at a specific sector in greater detail (a satellite model) or view the economy using a different paradigm or set of data. It is important to note that ToTEM2 and many of the other models used by the Canadian Economic Analysis Department rely critically on inputs provided by a Global Economy Model (GEM) and a detailed Model of the U.S. Economy (MUSE) constructed and overseen by the International Department, again supplemented with many other pieces of information. Since Canada is an open economy, international developments, such as movements in commodity prices, growth in Asian demand and prospects for the U.S. economy, play a major role in determining the path of the Canadian projection. The combined output of all these models and analyses is blended with judgment to produce a base-case or most likely scenario, which is presented in this first meeting with senior management. A number of key risks and alternative scenarios are also identified at the meeting. Staff will then work on these scenarios over the next two weeks in preparation for Stage 2 – the major briefing. Unlike Stage 1 – the presentation of the staff projection – which mainly involves the Canadian Economic Analysis Department and the International Department, Stage 2 draws importantly on all four economics departments. There are six key inputs to this meeting: 1. an updated monitoring of economic developments and risks; 2. the Business Outlook Survey, compiled by the Bank’s five regional offices; This is a very general description; the exact process may vary slightly for different FADs. The acronym stands for Terms-of-Trade Economic Model, version 2. BIS central bankers’ speeches 3. a report focusing on capacity pressures and alternative indicators of inflation; 4. an analysis of money and credit conditions; 5. the Bank’s Senior Loan Officer Survey; and 6. an overview of financial market conditions and monetary policy expectations in Canada, the United States and the rest of the world. Stage 3 – the policy recommendations of staff – typically occurs on Friday, two days after the major briefing. A senior member of the Canadian Economic Analysis Department or the International Department is asked to summarize and update the material that has been presented in Stages 1 and 2, and to provide a recommendation regarding any policy action that should be taken. The overview and recommendation serve as the starting point for an extensive discussion by the entire Monetary Policy Review Committee. Tactical and communications issues, as well as various policy options, are then reviewed, based on a note prepared by the Financial Markets Department. The meeting concludes with a tour de table at which each member of the MPRC, except for the six Governing Council members, is asked for a policy recommendation. Stage 4 – the decision by the Governing Council – begins on Friday afternoon, immediately after the Stage 3 discussions, and resumes on the following Monday. Members of the Governing Council are the policy decision-makers. They review the information and recommendations that they have received, exchange views and explore any outstanding issues. Further discussions are held on Monday, a decision is reached, and a press release is drafted and approved. The fifth and final Stage of the process – Communication – focuses on the publication of the press release at 9:00 a.m. on Tuesday announcing the Bank’s decision and explaining the reasons behind it. Four times a year, this message is reinforced and expanded upon with the release of a Monetary Policy Report one day later. The Report provides a more detailed account of Canadian and global economic developments, the Bank’s projections, and the major upside and downside risks that could affect the inflation outlook. In addition to this Report, two other publications are released four times a year, approximately one week before the interest rate decision. The Business Outlook Survey (BOS) summarizes the results of the quarterly interviews that the Bank’s five regional offices conduct with a representative sample of businesses across the country. This survey is an important complement to the other material that the MPRC and the Governing Council rely on and serves as a kind of “reality check” of what is happening on a regional basis. The second publication is the Senior Loan Officer Survey, which is based on interviews conducted with major banks and financial institutions in Canada to determine whether lending conditions for businesses have eased or tightened in the previous three months. The final elements of the Bank’s communication effort around these four Monetary Policy Reports involve a press conference by the Governor and the Senior Deputy Governor and Parliamentary appearances at the House of Commons Standing Committee on Finance, and the Senate Standing Committee on Banking, Trade and Commerce. As should be clear from the process I have just described, the Bank places a great deal of importance on communication. It is a critical part of our accountability to Canadians and enhances the effectiveness of monetary policy by deepening the public’s understanding of the economy and our actions. Three popular misconceptions about monetary policy Despite the emphasis that we put on communication and all the time that we devote to these activities, there is frequently some confusion in the minds of the public about what monetary policy does and the constraints that the Bank might operate under. I would like to take the BIS central bankers’ speeches last few minutes of my presentation, therefore, to discuss three of the most popular misconceptions. They are: 1. The Bank’s narrow focus on inflation ignores more important objectives such as full employment and a rising standard of living. Not true. Experience has shown that price stability is the most important contribution that the Bank can make to the economic well-being of Canadians. Since the introduction of inflation targeting in 1991, the low and stable inflation environment has allowed consumers and businesses to manage their finances with greater certainty about the future purchasing power of their savings and income. Interest rates have also been lower in both nominal and real terms across a range of maturities. More broadly, low, stable and predictable inflation has helped to encourage more stable economic growth in Canada as well as lower and less-variable unemployment. 2. If the Canadian economy is operating close to capacity (i.e., near full employment) and inflation is close to or at the 2 per cent target, interest rates have to be close to their “normal” or “neutral” levels. Not true. If there were no forces acting on the economy to push it away from this desired state, the statement would be true. However, this is seldom the case. Headwinds and tailwinds are often present, threatening to push economic activity and inflation higher or lower. Monetary policy needs to lean against these forces with opposing pressure from higher or lower interest rates in order to stabilize the economy and to keep inflation on target. Monetary policy is seldom static; it has to respond as these forces ease or escalate. 3. Focusing on price stability limits the Bank’s ability to pursue its other major objective, financial stability. Not true. While at times there may appear to be tensions between these objectives, the two are in fact inextricably linked; it is impossible to achieve one of them without maintaining the other. Although other policy levers, such as bank regulation and macroprudential tools, are typically the first lines of defence in ensuring financial stability, monetary policy can, in exceptional circumstances, play a complementary role in achieving this end. Fortunately, there is enough flexibility in the present monetary policy framework to do so while achieving our inflation target over the medium term. One is not sacrificed for the benefit of the other. Some concluding thoughts Canada’s monetary policy framework and the process that the Bank uses to make its decisions have evolved over time. The move to inflation targeting in 1991 and the move to fixed announcement dates are certainly the most noteworthy, but there have been many other refinements in the way policy is formulated and implemented. The process for decision-making that I have described is intensive and collaborative. It has also proved to be very effective. Without doubt, there will be further refinements in the future as we learn from new experiences. The effort to improve the decision-making process is ongoing. Thank you for your interest. I would be pleased to respond to any questions you might have. BIS central bankers’ speeches BIS central bankers’ speeches
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Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Association of Quebec Women in Finance, Montréal, Quebec, 14 June 2012
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Agathe Côté: Strengthening financial infrastructure – the new Canadian central counterparty Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Association of Quebec Women in Finance, Montréal, Quebec, 14 June 2012 * * * It gives me great pleasure to address the Association of Quebec Women in Finance. You are all aware that we are once again in the midst of a period of heightened financial turbulence. This current episode reminds us—if that was necessary—of how important it is to have a robust financial system. Today, I will briefly talk about the risks to which Canada’s financial system is currently exposed. However, my main focus will be on a major step that we have taken to strengthen our financial system against future shocks. I am referring to the new central counterparty service for repo transactions, which was launched on 21 February. This service, operated here in Montréal by the Canadian Derivatives Clearing Corporation (CDCC), is a key initiative designed to improve the infrastructure of Canadian core funding markets. Recall that our short-term funding markets, like those of many other countries, were severely battered in 2008. These markets are not immune to further turbulence, so it is important that we take measures to increase their resilience. CDCC worked closely with the Investment Industry Association of Canada, stakeholders in the financial industry, the Bank of Canada and other regulatory authorities to create this new central counterparty. However, much remains to be done. It is my hope that, by the time I conclude my comments, you will have a greater understanding of why it is essential that we continue with the next phases of implementation, in which the volume of transactions and the number of participants with access to the counterparty will be expanded. Risks presented in the Financial System Review But first, let’s talk about risk. Today, the Bank of Canada is releasing the latest issue of its Financial System Review, in which it analyzes the principal risks weighing on our country’s financial system. I am sure it’s not news to you that these risks remain high. After a period of calm earlier this year, global financial conditions have deteriorated markedly in recent weeks as the debt crisis in Europe has intensified. Markets are skeptical about the capacity and resolve of policy-makers to address unsustainable fiscal situations, the capital adequacy of some euro-area banks and the underlying balance-of-payments problems within the euro area. If these issues are not dealt with in an orderly way, the contagion effects on global financial conditions could be significant. While less urgent than the situation in Europe, the risks surrounding sovereign debt are also affecting other regions. In particular, in the United States the spectre of a “fiscal cliff” looms over that country’s prospects for growth. More generally, weakness in global demand that is partly due to international current account imbalances continues to represent a major source of risk. Moreover, in several advanced economies, keeping policy rates low over an extended period of time may stimulate excessive risk-taking. BIS central bankers’ speeches Here in Canada, the high level of indebtedness and the potential for a correction in the housing sector are the principal domestic risks facing the financial system. As well, the fragile situation abroad increases the probability of a negative shock to the incomes and wealth of Canadian households. To date, the crisis in Europe has had a limited impact on our financial system. Canadian markets have remained relatively stable, and our banks continue to have good access to wholesale funding markets. Nonetheless, a deterioration in the situation could have a considerable effect on Canada through trade, confidence and financial channels. Even though our financial system is solid, it is important to take further steps to bolster its ability to absorb shocks. The creation of a central counterparty for the repo market is a step in that direction. With your permission, I will now turn to the crucial role played by the repo market in Canada. The repo market Repos – transactions that involve selling a security while concurrently committing to repurchasing it at a later date for the sale price plus interest – are the economic equivalent of secured loans. Investment dealers and banks use the repo market as a source of low-cost secured financing to fund long positions and hedge short positions on securities. These activities allow market-makers to generate liquidity for the broader financial system and maintain liquid secondary markets. Other institutions, such as insurance companies and pension funds, also use the repo market as a tool to manage cash balances. Since a very large proportion of repo transactions are short term, the turnover rate in this market is high. These transactions provide the immediate margin of adjustment for financial institutions’ funding structures. To give you a sense of magnitude, on 30 March 2012, the repo positions on the securities of Canadian banks were valued at a total of Can$90 billion (approximately 5 per cent of their Canadian-dollar-denominated assets). Government of Canada securities provided the underlying collateral for almost 70 per cent of transactions. Hence, the repo market supports the functioning of crucial cash markets. In sum, the repo market is considered a core funding market in Canada, because it represents a major source of funds for financial institutions. In addition, there is no immediate substitute for this market, so if it were to cease operating, significant contagion would likely result.1 This is why we must make every effort to ensure that it remains continuously open. Risks brought to light by the crisis During the financial crisis of 2007–08, weakness in the infrastructures of some financial markets contributed to uncertainty and, although not the cause of the crisis, intensified the systemic risk. This was notably the case in repo markets. In fact, participants’ uncertainty about the valuation of collateral and the network of bilateral exposures among financial institutions exacerbated their aversion to counterparty risk, to the point that many reduced the number of trades and, in some cases, even left the market. J.-S. Fontaine, J. Selody and C. Wilkins, “Improving the Resilience of Core Funding Markets,” Bank of Canada Financial System Review (December 2009): 41–46. BIS central bankers’ speeches Recall that illiquidity in the repo market was an important contributor to the near-collapse of Bear Stearns in March of 2008. Repo markets in Canada suffered a severe liquidity crunch in the autumn of that year. Following the bankruptcy of major financial institutions abroad, concerns about counterparties spread, and balance sheets were subject to severe strains. In the absence of a CCP that would allow its members to ease their balance sheets through balance-sheet netting, banks drastically curtailed their repo activity. The crisis clearly demonstrated the need for action to bolster the resilience of this market. In Canada, the Investment Industry Association of Canada, with the support of the Bank of Canada, issued a request for proposal for the development of CCP services for repos. In December 2009, CDCC was selected to provide these services. The CCP for repo transactions and risk management How does this central counterparty work? Put simply, a central counterparty functions as an intermediary in financial transactions. Through a legal process called “novation,” it becomes the buyer for every seller and the seller for every buyer.2 In other words, a very complex network of bilateral exposures is replaced by one exposure to a hub, the central counterparty. This process does not, however, eliminate risks? risks that are now concentrated in a single institution. As a result, for a central counterparty to contribute to reducing systemic risk, it must have solid risk-control mechanisms in place and be subject to rigorous oversight. CDCC has implemented mechanisms to manage the various risks confronting it, notably, legal, operational and financial risk. With regard to financial risk, controlling both credit and liquidity risk is key to containing overall counterparty risk in the system.3 The legal rules that govern CDCC’s management of defaults, together with the financial resources available to it for addressing credit risk and liquidity risk, enhance the stability of the repo market by ensuring an orderly winding down in the event that a major institution defaults, while also ensuring that all novated transactions are settled. During the crisis, the benefits of a central counterparty became apparent with the bankruptcy of Lehman Brothers. Thanks to the participation of Lehman in a central counterparty for derivatives, its positions on interest rate swaps – which were enormous (US$9 trillion and more than 66,000 transactions) – were unwound in an orderly and timely fashion. Thus, the market for interest rate derivatives – another core market – continued to function smoothly despite the Lehman collapse. The role of the Bank of Canada In light of the crucial role played by this central counterparty service in the efficient functioning of the repo market, the Bank of Canada considered that the Canadian Derivatives Clearing Service (CDCS) might pose a systemic risk, whereupon it designated the CDCS under the Payment Clearing and Settlement Act. Consequently, CDCS has been subject to oversight by the Bank since 30 April 2012. N. Chande, N. Labelle and E. Tuer, “Central Counterparties and Systemic Risk,” Bank of Canada Financial System Review, (December 2010): 43–50. P. Chatterjee, L. Embree and P. Youngman, “Reducing Systemic Risk: Canada’s New Central Counterparty for the Fixed-Income Market,” Bank of Canada Financial System Review (June 2012): 43–49. BIS central bankers’ speeches The Bank’s oversight process includes reviewing significant changes to both the system and its operating rules, reviewing the results of audits, and defining standards. In carrying out its oversight mandate, the Bank works closely with the relevant financial market regulators, the Autorité des marchés financiers and the Ontario Securities Commission. This oversight will soon be based on new international standards developed with the participation of the Bank. It is worth noting that lessons learned during the creation of Canada’s central counterparty for repo transactions were very useful in the development of these new standards. Implementation of the central counterparty The metaphor frequently used by the industry to describe the financial system infrastructure is simple and appropriate: it’s called “plumbing.” Why? Because it is essential to the viability and efficient functioning of markets. As for our financial system, the plumbing is quite complicated. Hence, developing this new infrastructure took a great deal of time. It is a complex process, in terms of both creating and implementing adequate and robust risk-control mechanisms. Moreover, time is required to resolve operational issues, such as the development and testing of required software for both the central counterparty and the participants, and issues associated with the interaction between new software and existing systems. The launch of the first phase of the service therefore represents a major step. But much remains to be done. Delivery will take place in three phases. Phase one deals with bilateral repo transactions on a single Government of Canada security, although these represent only a small fraction of the market. Phase two, planned for the end of this year, will incorporate cash transactions on fixed-income securities and repo transactions negotiated by intermediaries, including those with anonymous counterparties. Finally, phase three, proposed for 2013–14, will target general-repo transactions in which any security in a predetermined basket of instruments can serve as collateral. The introduction of this last phase is expected to significantly increase the volume of trades made through the central counterparty, as well as the liquidity and efficiency of the repo market. International efforts to mitigate risk in Short-Term Funding Markets In Canada, the creation of a central counterparty will contribute significantly to limiting the risk of instability emanating from the repo market. At the international level, the Financial Stability Board is currently assessing potential reforms of repo markets and for loans of securities in the context of its work on the shadow banking sector.4 The repo market is part of this sector because it is a form of credit intermediation which, like banking intermediation, rests on maturity transformation and may include leverage effects. There are a number of possible reforms. Financial Stability Board, “Securities Lending and Repos: Market Overview and Financial Stability Issues,” Workstream on Securities Lending and Repos, Interim Report of the Shadow Banking Workstream 5, 15 March 2012. BIS central bankers’ speeches One of the specific measures under consideration is the increased use of central counterparties. Another promising avenue addresses the regulation of margins to mitigate the problems associated with procyclicality. Adopting minimal, or countercyclical, margins could help to curb excessive leveraging during periods of exuberance and lessen the extent of a disruptive curtailment of leveraging during difficult periods. Moreover, increased use of central counterparties for repos could facilitate the implementation of this type of regulation. Conclusion It was my intention today to talk about risks, but even more to shed some light on the significant strides taken in Canada to improve the resilience of our financial system. One tangible, and local, example of this progress has been the creation, right here in Montréal, of a central counterparty for repo transactions. Transactions executed by this counterparty are completely transparent and well capitalized, and there are rules and procedures in place in the event of default. Today, Canada’s experience is benefiting other countries and authorities. However, it’s worth emphasizing that it was the willingness of the private and public sectors to work together that led to the creation of this counterparty. It is essential that this spirit of co-operation be maintained, because much remains to be done. The success of this counterparty depends on the subsequent phases of implementation, which will broaden its sphere of influence. We will never have a risk-free financial system. That’s why we need to take measures to render it more resilient to shocks that may occur, either from abroad or domestically. Let us make the financial system stronger to build a more stable future. Thank you for your attention. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the Atlantic Institute for Market Studies, Halifax, Nova Scotia, 21 June 2012.
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Mark Carney: Financing the global transition Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the Atlantic Institute for Market Studies, Halifax, Nova Scotia, 21 June 2012. * * * Introduction I want to thank the Atlantic Institute for Market Studies (AIMS) for the invitation to speak here in Halifax. One of Halifax’s greatest entrepreneurs was Samuel Cunard, whose shipping empire, like this centre, still bears his name. Launched more than 100 years ago, the Cunard business prospered in the last great era of global change. In my remarks today, I will speak about the transformation currently under way in the global economy. In touching on the situation in Europe, and the challenges of the international monetary system, I will concentrate on the central role of an open, resilient financial system to sustained global growth. The transition to a multi-polar world I would like to start by putting the recent darkening of the global economic outlook in perspective. Europe has built a single market of 500 million people and 27 countries, with free movement of goods, services, capital and people. In the process, it has transformed the economies of southern and eastern Europe. It has also played a consistently positive role in rising above national interests to address global problems. On a global scale, never in history has economic integration involved so many people, such a variety of goods and so much capital. This process lifted hundreds of millions of people out of poverty and created the potential for hundreds of millions more to follow in their path. The gap between rich and poor countries has narrowed dramatically and soon the global middle class will outnumber the poor. The shrinking disparity between the United States and China is particularly striking. In 1990, GDP per capita in the United States was almost 30 times higher than in China; by 2010, this ratio had fallen to just six times. The crisis is accelerating this transformation. But this transition will not be smooth, and it is not preordained. Downside risks to Europe are materialising, threatening the pace of global growth. More broadly, the rebalancing of the global economy is stalled, as much of the advanced world remains mired in a prolonged deleveraging. During this challenging time, we must remember that realising Europe’s and globalisation’s potential requires an open system. It is reasonable to expect capital to flow, on a net basis, from advanced economies towards higher expected returns in emerging-market economies. This is what happened during the last wave of globalisation at the turn of the 20th century when Canada, then an emerging economy, ran current account deficits averaging 7 per cent of GDP over three decades. These were good imbalances. Imported capital was invested in productive capacity that later served to pay off the accumulated debts. Global imbalances over the past decade have too often been bad, if not positively un-Canadian. In some cases, public capital has flowed from emerging-market economies to BIS central bankers’ speeches advanced economies to be invested in non-tradable goods such as housing. In others, private flows overshot in a complacent, deregulated “new era”. Large current account imbalances are an inherent part of strong global growth, but in order to be sustainable, they must be: • the product of private decisions taken in a context of sound macroeconomic policies and robust market structures; and • financed by an open, resilient financial system. In many respects, the problems we face today are the product of two flawed monetary unions: one formal – the European monetary union; the other informal – Bretton Woods II. In both cases, financial reforms will be integral to the solution. European Monetary Union Europe’s problems today are partly a product of the initial success of the single currency. After the euro’s launch, the European financial system quickly became integrated, and cross-border lending exploded. Easy money fed booms, which flattered government fiscal positions and supported bank balance sheets. In aggregate, the euro area’s debt metrics may not look daunting: the total euro-area public debt burden is lower than that of the United States or Japan, and its current account with the rest of the world is roughly balanced, as it has been for some time. But as is now blindingly obvious, these aggregates mask large internal imbalances. For example, since 2007, public debt in Spain increased by 30 percentage points of GDP, in Portugal by 40 percentage points, in Greece by 50 percentage points and in Ireland by 80 percentage points...and counting. Much of these increases are the consequence of private losses in real estate and banking sectors. Indeed, the euro crisis reminds us that, one way or another, excessive private debts usually end up in the public sector. Further, price stability across the euro area has been composed of large differences in national inflation rates. In the eight-year run-up to the crisis, inflation in the crisis economies was about twice that of the core countries. Most importantly, unit labour costs in peripheral countries shot up relative to those in the core economies, particularly Germany. The resulting deterioration in competitiveness has made the continuation of past trends unsustainable. Europe is now stagnating. Its GDP is still more than 2 per cent below its pre-crisis peak, and private domestic demand sits a stunning 6 per cent below. The contraction is driving banking losses and fiscal shortfalls. These are understandably receiving much attention, but it should be remembered that these challenges are symptoms of an underlying sickness: a balance-of-payments crisis. What should the Europeans do? To repay the creditors in the core euro area countries, the debtors of the periphery must regain competitiveness. This will be neither easy nor quick. A sustained process of relative wage adjustment will be necessary, implying large declines in living standards in one-third of the euro area. A comprehensive adjustment is necessary. The burden cannot only be on increasing unemployment and falling wages in countries like Spain. Deflation in the peripheral countries will not likely prove any more tolerable than it did in the United Kingdom under the gold standard of the 1920s. An increase in German wages and private demand (and inflation) BIS central bankers’ speeches would ease the transition. It is striking that German real wages barely grew in the two decades before the crisis. Moreover, it is essential that the structural reforms now under way across the deficit countries boost productivity. With domestic incomes squeezed, some of the required investment will have to be financed abroad. Unfortunately, the European financial system has aggressively renationalised in recent months. Intra-European cross-border lending – which had been growing by 25 per cent per year in the run-up to the crisis – has been falling at a rate of 10 per cent per annum since. While the European Central Bank (ECB) has adroitly stepped into the breach, reliance on central bank lending is not a recipe for robust private investment. Bold steps are required to restore the single financial market. And bold steps are now under consideration. One example is the current European proposal to create a banking union. By centralising bank restructuring, re-capitalising banks with European rather than national resources, moving towards centralised (or federalised) supervisory oversight and harmonising (or better still mutualising) deposit insurance, Europe can break the increasingly toxic links between banks and sovereigns. The recent agreement to recapitalise the Spanish banking system marks progress towards a greater financial and fiscal union that will reinforce the monetary union. It is further evidence of Europe’s resolve to address its problems. If such measures are combined with swift implementation of the Financial Stability Board’s (FSB) financial reform agenda, which I will outline in a moment, there is a prospect of relaunching a deeper, more robust pan-European financial system. Bretton Woods II The second flawed monetary union is at the heart of the current international monetary system: the so-called Bretton Woods II arrangement, which is centred on China and the United States. The current international monetary system is a hybrid of, on the one hand, mainly major advanced economies with floating exchange rates and liberalised capital flows and, on the other, a group of countries that actively manage their exchange rates. The result is a system that does not facilitate timely and symmetric adjustment to shocks or structural change. For example, despite its economic miracle, China’s real exchange rate did not appreciate in the two decades before the global financial crisis. In the decade before the crisis erupted, China’s relentless accumulation of reserves contributed to low real interest rates and, for a time, subdued macroeconomic volatility. Market participants increasingly assumed this stable macroeconomic environment would persist – prompting a search for yield, rising leverage and a dramatic underpricing of risks. When combined with inadequate supervision of the financial system and ill-conceived deregulation of housing and financial markets, U.S. private non-financial debt quickly rose to levels last seen during the Great Depression. With 20 per cent of global output, the United States imported 60 per cent of global capital (on a net basis) on the eve of the crisis. This would not have been a problem if this capital had been invested in expanding productive capacity. Unfortunately, not enough of it was. Now, the debt cycle has decisively turned. Creditors demand repayment, and global growth will require global rebalancing. BIS central bankers’ speeches How to pay down debt Austerity is a necessary condition for rebalancing, but it is seldom sufficient. There are really only three options to reduce debt: restructuring, inflation and growth. Whether we like it or not, debt restructuring may happen. If it is to be done, it is best done quickly, and on a sufficient scale to restore sustainability. Policy-makers need to be careful about delaying the inevitable and merely funding the private exit. Some have suggested that higher inflation may be a way out from the burden of excessive debt. To be effective, this would need to be coupled with various forms of financial repression, including capital controls and forced holdings of government debt. This is a counsel of despair. An inflation surprise needs to be very large or very sudden to work. Moving opportunistically to a higher inflation target would risk unmooring inflation expectations, destroying the hardwon gains that have come from the entrenchment of price stability, and increasing real rates that would exacerbate unfavourable debt dynamics. Financial repression would have to be both massive and sustained. It would undermine the system that has helped bring us the prosperity of the past three decades. The most palatable strategy to reduce debt is to increase growth. Private growth will not flourish in an environment of macro instability. Fiscal sustainability and price stability are essentials, not luxuries. Private growth needs an enabling environment, including tax competitiveness and a framework for infrastructure investment. It needs a sound financial sector that is diverse, resilient and open. Sustainable private growth and the role of financial reform This is not yet assured. Most immediately, there is a risk that a series of contingency measures could extend to a global scale the current European trend towards renationalisation. That is one reason why the European initiatives expected in the coming weeks are so important. More broadly, the financial reform agenda must address legitimate emerging-market concerns over the resiliency of the advanced-economy financial systems. Because of these worries, there is pressure for localisation to protect domestic systems and renewed use of capital controls to dampen the volatility of cross-border flows. If allowed to persist, these nascent trends could seriously restrain the global capital flows necessary for the next stage of the global transformation. The imbalance between states and markets I recall the German Finance Minister, Peer Steinbrück, at a fateful G-7 meeting in the wake of Lehman’s failure, relating that he had met a woman in East Germany earlier that week who told him that: “I have seen the fall of communism and now I am seeing the fall of capitalism.” The complete loss of confidence in private finance at that time could only be arrested by the provision of comprehensive backstops by the richest economies in the world. Even with these heroic efforts, the global financial crisis has cost $4 trillion in lost output and 28 million lost jobs, and built perilous 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. BIS central bankers’ speeches To restore confidence in the system, we must create a truly global system, in part by rebalancing the relationship between governments and markets. Governments must discard the myth that finance is self-regulating and self-stabilising, and financial policy-making can no longer be concentrated at national levels. Given the reality of global finance, it is not enough to have our own house in order unless we seal ourselves off from the world – and if we were to do that we will end up much poorer. An open, resilient global financial system will be central to the transformation of the global economy. In order to achieve that, financial sector reform is a must. The G-20 has a serious agenda, being aggressively implemented. The current intensification of the euro crisis has only sharpened our resolve. Building resilient financial institutions Achieving a stronger banking system is the overriding priority, hence the importance assigned to full implementation of Basel capital and liquidity standards. A simple, but effective, leverage standard has been imported from Canada. It will protect the system from risks we think are low but in fact are not. These measures have lowered the probability of failure. However, our goal is not a fully risk-proofed system. That is neither attainable nor desirable. Ending too-big-to-fail Since failures will still happen, there remains the need to reduce their impact, which is one of the reasons to focus on ending too-big-to-fail. More fundamentally, we must address, once and for all, the unfairness of a system that privatises gains and socialises losses. By restoring capitalism to the capitalists, discipline in the system will increase and, with time, systemic risks will be reduced. Most importantly, the knowledge that major firms in markets far away can fail, without meaningful consequences at home, will restore confidence in an open global system. To achieve this objective, bondholders, shareholders and management – rather than taxpayers – must bear the brunt of losses. To this end, all FSB member countries have committed to have in place a bail-in authority. In addition, each global systemically important bank must have in place a Resolution and Recovery Plan within the next six months, to be supplemented by cross-border co-operation agreements. The framework for systemic institutions is now being extended to domestic banks, global insurers, and key shadow banks. When implemented, greater supervisory intensity and higher loss absorbency will ensure that the system is never again beholden to the fate of a single firm or group of firms. Creating continuously open markets An important element of ending too-big-to-fail is ensuring that key markets can withstand the failure of systemic firms. It is unacceptable that core markets seized up during crisis, and that relatively small firms had to be saved because of concerns that they would take markets with them if they failed. Creating continuously open core markets requires changes to the plumbing of derivative and repo markets, along with better data and tracking of exposures. Moving from shadow banking to market-based finance The FSB is working to strengthen the oversight and regulation of shadow banking so that it is a source of competition (to promote efficiency) and diversity (to promote resilience) to the regulated sector. This will require changes to how money-market funds are managed, the BIS central bankers’ speeches terms of securitisation and, most importantly, how links between the regulated banking sector and shadow banks are managed. Timely, consistent implementation Finally, the FSB is increasingly focused on timely, full and consistent implementation of agreed reforms. This is essential to preserve the advantages of an open and globally integrated financial system. Recent experience demonstrates that when mutual confidence is lost, the retreat from an open and integrated system can occur rapidly. A return to a nationally segmented global financial system would reduce both systemic resilience and financial capacity for investment and growth. Conclusion Let me conclude with some comments on the current economic environment. The recoveries in advanced economies continue to be dampened by the ongoing need to repair sovereign, bank and household balance sheets. While the U.S. economy is expanding at a modest pace, some of the risks around the European crisis are materialising and risks remain skewed to the downside. The emerging world continues to be the engine of global growth, although weak demand in advanced economies and the effects of past policy tightening are slowing the pace of expansion in China and other major emerging-market economies. As a result of more modest global economic momentum and heightened financial risk aversion, commodity prices have fallen in recent months, although they remain at historically elevated levels. Despite these ongoing global headwinds, the Canadian economy continues to grow with an underlying momentum consistent with the gradual absorption of the remaining small degree of economic slack. Total CPI inflation is expected to fall below 2 per cent in the short term, as a result of lower gasoline prices, while core inflation is expected to remain around 2 per cent. Canada’s relatively favourable economic performance continues to rely significantly on the resilience of Canadian household spending, supported by very accommodative monetary policy and a well-functioning financial system. Our economy cannot, however, depend indefinitely on debt-fuelled household expenditures, particularly in an environment of modest income growth. Notably, housing investment rose further in the first quarter, accounting for an unusually elevated share of the overall Canadian economy. In this context, Canadian authorities are co-operating closely to monitor the financial situation of the household sector, and are responding appropriately. Today, federal authorities have taken additional prudent and timely measures to support the long-term stability of the Canadian housing market, and mitigate the risk of financial excesses. Against this backdrop, to the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term. The timing and degree of any such withdrawal will be weighed carefully against domestic and global economic developments. As I have argued today, these global developments will depend importantly on sustaining an open, global system. At the G-20 meeting this week in Los Cabos, Mexico, leaders reaffirmed that “multilateralism is of even greater importance in the current climate, and remains our best asset to resolve the global economy’s difficulties”, and committed to “timely, full and consistent implementation of agreed policies to support a stable and integrated global financial system”. BIS central bankers’ speeches This resolve bodes well for securing the global transformation and, with it, realising the full potential of Canadian prosperity. BIS central bankers’ speeches
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the press conference following the release of the Monetary Policy Report, Ottawa, 18 July 2012.
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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 and Chairman of the Financial Stability Board, at the press conference following the release of the Monetary Policy Report, Ottawa, 18 July 2012. * * * 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. Global growth prospects have weakened since the Bank released its April MPR. The economic expansion in the United States continues at a gradual but somewhat slower pace, while developments in Europe point to a renewed contraction. In China and other emerging economies, the deceleration in growth has been greater than anticipated, reflecting past policy tightening and weaker external demand. This slowdown in global activity has led to a sizeable reduction in commodity prices, although they remain elevated. The combination of increasing global excess capacity over the projection horizon and reduced commodity prices is expected to moderate global inflationary pressures. Global financial conditions have also deteriorated since April, with periods of considerable volatility. While global headwinds are restraining Canadian economic activity, domestic factors are expected to support moderate growth in Canada. The Bank expects the economy to grow at a pace roughly in line with its production potential in the near term, before picking up through 2013. Consumption and business investment are expected to be the primary drivers of growth, reflecting very stimulative domestic financial conditions. However, their pace will be influenced by external headwinds, notably the effects of lower commodity prices on Canadian incomes and wealth, as well as by record-high household debt. Housing activity is expected to slow from record levels. Government spending is not projected to contribute to growth in 2012. It is expected to contribute only modestly thereafter, in line with plans to consolidate spending by federal and provincial governments. Canadian exports are projected to remain below their pre-recession peak until the beginning of 2014. This reflects the dynamics of foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. The Bank projects that the economy will grow by 2.1 per cent in 2012, 2.3 per cent in 2013 and 2.5 per cent in 2014. The economy is expected to reach full capacity in the second half of 2013, thus operating with a small amount of slack for somewhat longer than previously anticipated. Core inflation is forecast to remain around 2 per cent over the projection horizon as the economy operates near its production potential, growth in labour compensation stays moderate and inflation expectations remain well anchored. Given the recent drop in gasoline prices and with futures prices suggesting persistently lower oil prices, the Bank expects total CPI inflation to remain noticeably below the 2 per cent target over the coming year before returning to target around mid-2013. The inflation outlook in Canada is subject to significant risks. BIS central bankers’ speeches The three main upside risks to inflation in Canada relate to the possibility of higher global inflationary pressures, stronger Canadian exports and stronger momentum in Canadian household spending. The three main downside risks to inflation in Canada relate to the European crisis, weaker global momentum and the possibility that growth in Canadian household spending could be weaker. Overall, the Bank judges that the risks to the inflation outlook in Canada are roughly balanced over the projection period. Reflecting all of these factors, the Bank yesterday maintained the target for the overnight rate at 1 per cent. To the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term. The timing and degree of any such withdrawal will be weighed carefully against domestic and global economic developments. 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 Canadian Association for Business Economics, Kingston, Ontario, 21 August 2012.
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Agathe Côté: Modelling risks to the financial system Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Canadian Association for Business Economics, Kingston, Ontario, 21 August 2012. * * * Introduction It has become a summer tradition for the Bank of Canada to address the Canadian Association for Business Economics. This year it is my pleasure and I thank you for the kind invitation. An audience of colleagues and fellow economists offers me an opportunity to delve into a complex subject, and one that is particularly timely: financial system risk. We continue to see today the enormous costs to the global economy of the financial crisis that started five years ago. Of the many lessons we have learned from the crisis, a key one is this: we need to pay more attention to the stability of the financial system as a whole. This means understanding better how risks get transmitted across financial institutions and markets, and understanding better the feedback loop between the financial system and the real economy. From a policy perspective, this means taking a system-wide approach to financial regulation and supervision. Major reforms of the global financial system now under way address this need. System-wide risk has been a focus of attention at the Bank of Canada, and at other central banks, for some time. Ten years ago, the Bank issued the first edition of its semi-annual Financial System Review in which it identifies key sources of risks to the Canadian financial system and highlights the policies needed to address them. A year later, in 2003, we organized our annual conference on the theme of financial stability. 1 In the wake of the global financial crisis, the Bank has intensified its research efforts in this area. In particular, a priority is to improve the theoretical and empirical models we use to analyze elements of the financial system that can lead to the emergence of risks and vulnerabilities. With more finely tuned quantitative models and tools, the Bank will be better able to identify risks on a timely basis so that the private sector and policy-makers can take corrective action to support financial stability. Let me acknowledge upfront that this task is complex. While macroeconomic models have long been used to guide monetary policy decisions by central banks, models of financial stability and systemic risk are much less advanced. In my remarks today, I want to talk about the progress that we have made at the Bank in modelling risks to the financial system. I will start by briefly describing the notion of systemic risk and various approaches used to identify and measure it. I will then discuss two state-of-the-art quantitative models that we have developed to improve our assessment of risks to the Canadian financial system. The multiple dimensions of systemic risk Systemic, or system-wide, risk goes beyond individual institutions and markets. It is the risk that the financial system as a whole becomes impaired and that the provision of key financial services breaks down, with potentially serious consequences for the real economy. Bank of Canada annual conference on “The Evolving Financial System and Public Policy” held in December 2003 in Ottawa. BIS central bankers’ speeches Systemic risk manifests itself in different ways. There is a time dimension, which refers to the accumulation of imbalances over time, and a cross-sectional dimension, which refers to how risk is distributed throughout the financial system at a given point in time. Procyclicality is the key issue in the time dimension. It reflects the tendency to take on excessive risk during economic upswings – too much punch from the punchbowl, if you will – and to become overly risk averse during the downturns. Procyclicality makes the financial system and the economy more vulnerable to shocks, and increases the likelihood of financial distress. Risk concentrations and interconnections are the key issues in the cross-sectional dimension. Financial institutions can have similar exposures to shocks or be linked through balance sheets. As a result, losses in one institution can lead to fears of contagion that amplify the adverse effects of the initial shock. For instance, uncertainty about the viability of counterparties can lead to hoarding of liquidity, which may seem like an appropriate action for the individual institution but can have disastrous consequences for the financial system as a whole. System-wide surveillance requires that we regularly assess the importance of various types of systemic risk. How we judge a particular risk will be based on the probability that it will lead to financial system distress, and on the extent of its impact should that distress materialize. Early-warning indicators A fundamental challenge is to detect the risks arising from both global and domestic sources in an environment with a vast number of potential indicators. Therefore, one direction of research at the Bank has been to isolate the key signals from this broad information set by identifying a smaller group of variables that can serve as early-warning indicators of emerging imbalances. Since financial crises in Canada have been rare, international data are used to help establish numerical thresholds for each domestic indicator. For example, if international evidence suggests that credit growth above a certain rate tends to be associated with increased risk, then a period with credit growth above the threshold would suggest an elevated probability of financial stress. Selecting the level of thresholds involves a difficult trade-off between false alarms and failure to signal an event, so in practice the early-warning indicators are used mainly to identify areas where more detailed investigation may be warranted. They provide an objective, practical starting point to detect the buildup of imbalances in the financial system. One early-warning indicator that we regularly track is the deviation of the aggregate private sector credit-to-GDP ratio from its trend (the credit-to-GDP gap), which serves as a rough measure of excessive leverage across the financial system (Chart 1). This indicator has been shown to provide some leading information as a predictor of banking crises, and has been proposed by the Basel Committee on Banking Supervision (BCBS) as a useful guide for decisions about when to activate the countercyclical capital buffer – an important macroprudential policy instrument in the Basel III agreement. 2 Given the complexity of systemic risk, it is unrealistic to expect a single measure or indicator to serve all purposes. Combining indicators can produce better signals with fewer false alarms and undetected crises. For example, research shows that combining the See D. X. Chen and I. Christensen, “The Countercyclical Bank Capital Buffer: Insights for Canada.” Bank of Canada Financial System Review (December 2010): 29–34. BIS central bankers’ speeches credit-to-GDP gap with a measure of real estate prices produces an indicator that performs better than either variable on its own. 3 Our own work at the Bank reinforces findings elsewhere that aggregate private sector credit and real estate prices are among the most reliable indicators of financial stress. Identifying sources of risk is essential, but so is determining the likelihood that these risks will materialize. Therefore, another important aspect of ongoing research is the development of statistical models to help us forecast the probability that a crisis will occur based on a group of indicators. 4 Macro stress tests Early-warning indicators are useful to gauge the probability of financial stress, but a thorough assessment also requires an analysis of what could happen if the risk materializes. This is the goal of macro stress testing. A good part of the Bank’s efforts in recent years has been devoted to developing and refining stress-testing models. This class of models takes a large but plausible macroeconomic shock as a starting point and analyzes its impact on the balance sheets of banks or other sectors of the economy. The Bank now has two main stress-testing models to help monitor risks to the financial system. These models can also be used to assess the potential impact of policy tools or regulatory actions in mitigating financial system risks. Assessing risks from elevated household debt The first, the Household Risk Assessment Model, or HRAM, is a microsimulation model that assesses how the debt burden of Canadian households can affect financial stability. Using microdata from household balance sheets, the model allows us to estimate how various shocks would affect the distribution of debt within the household sector. The simulations take into account changes over time in individual debt levels, as well as changes in household wealth from savings and fluctuations in the value of financial assets. Tracking the asset side of household balance sheets gives us a more accurate picture of systemic risk since changes in wealth affect households’ ability to pay their debt. Household vulnerabilities depend not only on the average level of debt, but also on how debt is distributed across individuals. One strength of the model is precisely its ability to account for this distribution. For instance, while record-low interest rates in recent years have contributed to a relatively low aggregate household debt-service ratio, the share of Canadian households that are considered most vulnerable – those with a debt-service ratio equal to or higher than 40 per cent – has climbed to above-average levels, as has the proportion of debt held by these vulnerable households (Chart 2). Using HRAM, we estimate that if interest rates were to rise to 4.25 per cent by mid-2015, the share of highly indebted households would rise from slightly above 6 per cent in 2011 to roughly 10 per cent by 2016, while the proportion of debt held by these households would rise from 11.5 per cent to about 20 per cent over the same period. So while the aggregate household debt-service ratio paints a somewhat rosy picture, taking into account distributions gives us a clearer and more cautionary indication of how vulnerable our financial system actually is to household debt. See C. Borio and M. Drehmann, “Assessing the Risk of Banking Crises – Revisited,” BIS Quarterly Review (March 2009): 29–46. The Bank of Canada is also conducting research on approaches to combine indicators. For example, logit and probit models are used widely to calculate the probability of a crisis. BIS central bankers’ speeches Another strength of the model is that it provides a flexible tool for simulating the impact on household solvency of a wide range of potential shocks, such as an increase in unemployment. HRAM indicates that household loans in arrears would more than double under a severe labour market shock similar to that observed in the recession of the early 1990s. Despite the model’s strengths, we continue to enhance our analysis by improving HRAM. Expanding the behavioural aspects of the model is one way to do this. For instance, the model currently allows distressed households to pay their debts by selling their liquid assets, but not their homes. Work is also under way to improve the design of the shock scenarios. Results of stress tests using HRAM are regularly reported in the Bank’s Financial System Review and constitute an important element of our overall assessment of the risks associated with household finances. Assessing contagion effects in the banking system HRAM provides invaluable information on vulnerabilities in the household sector, but the Bank is also interested in assessing risks more broadly within the Canadian financial system. To this end, we have been working for several years on developing a MacroFinancial Risk Assessment Framework (or MFRAF). 5 Drawing on detailed data from bank balance sheets, MFRAF is a quantitative model that tracks the contribution of individual banks to systemic risk. Traditional stress-testing models focus exclusively on solvency risk, and estimate the overall risk to the financial system by simply aggregating credit (or other asset) losses that would materialize at individual banks in the event of a severe shock. MFRAF goes beyond this traditional approach by taking into account linkages among banks arising from counterparty exposures – or network spillover effects – as well as funding liquidity risk, that is, the risk of market-based runs on banks. The financial crisis illustrated the significant risks associated with a deterioration of funding liquidity. The collective reactions of market participants led to mutually reinforcing solvency and liquidity problems at banks around the world. As funding liquidity evaporated, many well-capitalized institutions had to take writedowns on illiquid assets, or sell them at a loss, creating uncertainty in the market about their solvency and adding to the downward pressure on asset prices. MFRAF has been built to integrate funding liquidity risk as an endogenous outcome of the interactions between solvency concerns and the liquidity profiles of banks. This strong microeconomic foundation constitutes a major innovation in macro stress-testing models. MFRAF also incorporates network externalities caused by the defaults of counterparties, with the size of a counterparty’s interbank exposures increasing the likelihood of spillover effects. A key lesson from the model is that failure to account for either funding liquidity risk or interbank exposures could lead to significant underestimation of the risks to the financial system as a whole if the banking system is undercapitalized and relies extensively on the short-term funding market. 6 Importantly, the loss distributions generated by the model exhibit fat tails, a key feature of the actual distribution of financial system risks (Chart 3). 7 Work on MFRAF started in 2006, ahead of the 2007 IMF-FSAP exercise for Canada which involved the assessment of the Canadian banking sector using a credit-risk model only. The analytical foundation of MFRAF is based on the work by S. Morris and H. S. Shin, “Illiquidity Component of Credit Risk,” Princeton University, 2009, which provides a theoretical framework for roll-over risk, and by F. Allen and D. Gale, “Financial Contagion,” Journal of Political Economy 108, 1 (2000):1–33, which explores the spread of contagion in a banking network. This hypothetical banking system consists of six major banks whose main balance-sheet parameters (capital ratio level, reliance on short-term funding and holdings of liquid assets) are in line with those observed in 2007 BIS central bankers’ speeches The fact that the model is able to replicate this important stylized fact demonstrates that it has significant potential as a tool for assessing systemic risk. Nevertheless, while MFRAF is already somewhat complex, the layers of interaction will need to be further augmented. For instance, the model misses any negative feedback that could occur between heightened risks to the banking system and the real economy. The model could also be expanded over time to include other types of financial institutions and markets. Compared with other approaches that use market-based data, such as the asset-pricing approach, the transmission channel in models like MFRAF is transparent, and this improves our interpretation of results. Because of this “story-telling” ability, many central banks have begun to use this type of framework in their financial stability analysis. 8 In addition to assessing risks, MFRAF can be used to examine the merits of policy or regulatory initiatives such as capital and liquidity rules. As the model becomes more refined, the objective is to use it more to complement other existing macro stress-testing exercises and to sharpen our analysis and communication of risks in the Bank’s Financial System Review. Conclusion Let me conclude. The Bank of Canada is conducting extensive research into finding methodologies and tools to identify and measure systemic risk. While work in this area is extremely complex, the Bank has made substantial progress in recent years. We now have two state-of-the art models. And with HRAM, the Bank of Canada is one of the few central banks at the leading edge of using microsimulation models to assess vulnerabilities in the household sector. Our efforts to build these models have provided us with important lessons. First, distributions matter – we cannot rely solely on aggregate data: distributional features and complex interactions are very important for assessing risks. This means developing models that capture these effects. Our household simulation model is aimed directly at understanding how the distribution of debts, assets and income affects financial stability. MFRAF uses information about the interconnections of individual financial institutions because these can lead to non-linear network effects that are also important for assessing systemic risks. Second, predicting behaviour under stress conditions is very difficult. Models need to be able to handle a variety of “what-if” scenarios corresponding to different assumptions about behaviours under stress. Finally, we need to consider the many different sources of risk to the financial sector and take into account their cumulative effects and interactions; otherwise we may underestimate risks. for international banks that were bailed out during the crisis. See C. Gauthier and M. Souissi, “Understanding Systemic Risk in the Banking Sector: A MacroFinancial Risk Assessment Framework,” Bank of Canada Review (Spring 2012): 29–38. See A. Haldane, “Tails of the Unexpected,” speech to the University of Edinburgh Business School, 8 June 2012). See C. Borio and M. Drehmann, “Assessing the Risk of Banking Crises - Revisited,” BIS Quarterly Review (March 2009): 29–46. Also see A. Foglia, “Stress Testing Credit Risk: A Survey of Authorities’ Approaches,” International Journal of Central Banking 5, no. 3 (2009): 9–45. BIS central bankers’ speeches Obviously, quantitative measures alone will never be enough to get a complete picture, especially since the financial system evolves rapidly. Intelligence gathered from discussions with the financial sector, as well as information shared with other policy-makers and supervisors here in Canada and in the international community, will always be critical to the overall assessment of the risks. While we are making progress, it is important to remember that financial system modelling is still in its infancy. The goal – understanding, preventing, and reducing systemic |risk – deserves our attention, diligent research and hard work. It has been my pleasure to share some of the Bank’s efforts with you today. Thank you very much. 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 and Chairman of the Financial Stability Board, to the Canadian Auto Workers (CAW), Toronto, Ontario, 22 August 2012.
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Mark Carney: Globalisation, financial stability and employment Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Canadian Auto Workers (CAW), Toronto, Ontario, 22 August 2012. * * * Introduction Thank you, Ken Lewenza for the invitation to be here today. You said last December that you would write to me to make sure you “get at least a couple of years as CAW National President, without having to face another world crisis.” The least I could do is show up to discuss how we are doing to fulfill such an entirely reasonable request. The global financial crisis has had a devastating impact. In the wake of Lehman’s demise, global trade fell 10 per cent and industrial production 18 per cent. Canadian manufacturing output dropped about 20 per cent and auto production 70 per cent. Twenty-eight million jobs were lost worldwide, including at its peak, 430,000 here in Canada. Your membership was particularly hard hit, with reverberations that continue today. The financial crisis and ensuing global recession demonstrated the fundamental interconnectedness of the global economy. When built on bedrock, interconnections of trade and investment create jobs and prosperity, including the $400 billion in goods exports in industries represented by your members. However, when built on sand, as was the case for too much of financial activity pre-Lehman, the global economy can transmit instability, uncertainty and unemployment. I want to discuss today what we can do to build the foundations for the right kind of globalisation, so that you can concentrate on creating prosperity for your families and fellow Canadians. Some of this is the direct responsibility of central banks; some is the work of the international policy-makers at the Financial Stability Board (FSB). And some is your responsibility: to continue to help grow flexible, productive companies that can succeed in a fiercely competitive global marketplace. Securing financial stability for jobs and growth Let me start with what policy-makers can do to ensure that businesses can get the capital they need to invest and hire, and further, that we do not experience a sudden shock in Canada from events abroad. Building resilient financial institutions Achieving a stronger global banking system is the overriding priority. This means more capital. Before the crisis, international banks operated with $50 of assets for every dollar of capital. With only a 2 per cent decline in the value of their assets, banks saw their capital wiped out. Not far off from your description, Ken, of having “no money in the vault” to back up their loans. 1 In response, international regulators have increased the minimum amount of capital banks must hold by about five times and are making the largest, most complex firms hold even more. In addition, we have added a safety belt imported from Canada with a simple, but effective, leverage standard. This protects the system from risks we think are low but in fact are not. Canadian Auto Workers (CWA) President Ken Lewenza speech to the CAW Council, p. 6, December 2, 2011. BIS central bankers’ speeches Ending too-big-to-fail These measures have lowered the probability of failure, but since failures will still happen, their impact must be reduced, which is one of the reasons to focus on ending “too-big-to-fail.” We must address, once and for all, the unfairness of a system that privatises gains and socialises losses. By restoring capitalism to the capitalists, discipline in the system will increase and, with time, systemic risks will be reduced. In addition, the knowledge that major firms in markets far away can fail, without meaningful consequences at home, will restore confidence in an open global system and allow Ken and all of us to focus on our day jobs. To ensure that bondholders, shareholders and management – rather than taxpayers – bear the brunt of losses, all FSB member countries have committed to have in place a bail-in authority and will have specific plans by the end of this year to recover or, if necessary, resolve these firms. The framework for systemic institutions is now being extended to domestic banks, global insurers, and key shadow banks, such as hedge funds. When implemented, greater supervisory intensity and higher loss absorbency will ensure that the financial system is never again beholden to the fate of a single firm or group of firms. Creating continuously open markets An important element of ending too-big-to-fail is ensuring that key markets can withstand the failure of firms. Creating continuously open core markets requires changes to the plumbing of derivative and repo markets, along with better data and tracking of exposures. Moving from shadow banking to market-based finance Finally, the FSB is working to strengthen the oversight and regulation of shadow banking so that it is a source of competition (to promote efficiency) and diversity (to promote resilience) to the regulated sector. This will require changes to how money-market funds are managed, the terms of securitisation and, most importantly, how links between the regulated banking sector and shadow banks are managed. Let me give a Canadian example of why this is important. In the summer of 2007, the Canadian non-bank ABCP market froze (Chart 1). As a consequence, auto leasing disappeared almost overnight (Chart 2). Prior to this point, about 40 per cent of cars in Canada had been purchased with a lease. Canadian banks stepped into the breach helping to ensure that Canadian auto demand dramatically outperformed American demand. Now we need to rebuild securitization so that Canadian consumers have low-cost financial alternatives. These reforms will make a huge difference – if they are implemented. Canada learned during the last crisis that having our own house in order is not enough. We need others to raise their game. That is why the FSB is increasingly focused on timely and consistent implementation of agreed reforms. We will identify those who drag their feet or bend the rules and hold them to account. Recent developments in Canadian labour markets Globally, workers felt the brunt of the financial crisis. Yet, given its severity, Canada’s labour market has performed well, both in absolute terms and relative to other advanced economies. All of the jobs lost in the recession have been recovered and a further 304,000 jobs have been created (Chart 3). Since the trough, the vast majority of these jobs have been full-time and in the private sector. Nearly all new jobs are in industries that pay above-average wages. BIS central bankers’ speeches After peaking at 8.7 per cent in August 2009, Canada’s unemployment rate has fallen to its current level of 7.3 per cent. While it has not yet returned to its pre-crisis low, this is in part because our working-age population has continued to grow and potential workers have continued to look for work. This stands in stark contrast to the situation in the United States, where a large number of workers have become discouraged and left the labour market. Over 40 per cent of unemployed U.S. workers are long-term unemployed (compared with 18 per cent of Canada’s unemployed workers). And the American unemployment rate stands 1 percentage point above Canada’s (and a full 2 percentage points when measured on a like-for-like basis). While Canada’s labour market has performed better than most other G-7 economies, we all know there is still slack (Chart 4). The participation rate has not fully recovered and the percentage of involuntary part-time workers has risen about 5 percentage points (Chart 5). In addition, wage growth has been moderate and is expected to remain so. This is one reason why monetary policy has been so exceptionally accommodative for so long. Interest rates have been at or near historic lows since the crisis began. Adjusted for CPI inflation, the policy real interest rate has been negative, on average, since the end of 2008. With a well-functioning financial system, the Bank has provided exceptional policy stimulus to our economy, consistent with growing activity and employment and consistent with achieving our inflation target. Longer-term trends Any analysis of recent employment performance should consider the broader context of an evolving workplace in the global economy. First, the share of employment in manufacturing has steadily declined across advanced economies, falling from 25 per cent to 14 per cent in the three decades leading up to the crisis. Even in Germany, the share of employment fell from 32 per cent to 19 per cent over this period. In this context, Canada’s record is about average, with a decline from 18 per cent three decades ago to about 10 per cent today (Chart 6). In part, this reflects the substitution of capital for labour, such as the increased use of robotics on assembly lines. It also reflects the changing nature of globalisation. In both goods and services, the current wave of globalisation is changing the nature of production and the demand for labour. In the first wave of globalisation at the turn of the last century, the combination of sharp falls in transportation costs and large economies of scale in factories promoted the concentration of production and manufacturing employment. In the current wave, which began in the late 1980s, huge advances in communications and computing technologies have dramatically lowered the costs of coordination across stages of production. This has promoted the distribution of these stages to the most cost-effective locations. One consequence has been a shift of fabrication jobs to low-wage locations in emerging markets. Even in services, complex tasks, such as professional and health services, are now being separated into their higher-value-added and routine components, leading to outsourcing and job displacement. With companies increasingly part of global supply chains, competitive advantage will increasingly be concentrated in stages of production (such as engineering and design or fabrication) rather than specific sectors (such as aerospace or automobiles). BIS central bankers’ speeches In general, these trends mean that the demand for unskilled workers in advanced economies is falling relative to that for skilled workers. Some estimates show that by the end of this decade, there will be a shortage of 18 million skilled workers and a surplus of 35 million unskilled workers across advanced countries. 2 These broad shifts in the demand for and supply of labour are contributing to rising inequality. Over the past 20-plus years, incomes in Canada have increased nearly twice as fast for earners in the top 10 per cent as for those in the lowest 10 per cent. The share of the top 1 per cent is now the third highest among member-countries of the Organization for Economic Co-operation and Development (OECD) after the United States and the United Kingdom. 3 The last time inequality in the United States was this severe was during the 1920s. Moreover, labour’s share of national income is now at its lowest level in half a century across most advanced economies, including Canada. When income inequality is measured using the Gini coefficient, the most widely-used metric of income inequality, Canada falls in the middle of OECD countries. We all need to recognise that the durable, high-paying manufacturing jobs of the future will be located in companies that invest to equip and train their workers and that are fully engaged in the global economy. Macroeconomic context A strategy to grow good jobs in this environment must also take into account the global economic transformation currently under way. It starts by recognising the limits of relying on our home market. In the immediate aftermath of the crisis, the broad economic strategy in Canada has been to grow domestic demand and to encourage Canadian businesses to retool and reorient to the new global economy. Stimulative monetary and fiscal policies proved highly effective in supporting a robust growth in domestic demand, particularly household expenditures. For example, after falling almost 20 per cent in the recession, Canadian auto sales rebounded strongly and now are slightly less than 4 per cent above their pre-recession level. As effective as it has been, the limits of this growth model are becoming clear. In particular, we cannot grow indefinitely by relying on Canadian households increasing their borrowing relative to income. In the decade leading up to the recession, Canadians tapped the wealth in their homes to finance up to one-fifth of consumption growth. Housing activity is now near a record share of GDP, and there are increasing signs of overbuilding and overvaluation in segments of the real estate market. In response, the federal government has instituted four prudent and timely tightenings of mortgage insurance terms. OSFI has introduced tougher underwriting standards for home-equity loans and enhanced supervisory scrutiny. Monetary policy has remained focused on the inflation target, although under flexible inflation targeting the Bank of Canada is prepared to support regulatory efforts, if necessary, and consistent with price stability over the medium term, to ensure balanced and sustainable growth. 4 R. Dobbs et al., “The World at Work: Jobs, Pay, and Skills for 3.5 Billion People,” McKinsey Global Institute, June 2012. This share grew from 9 per cent in 1990 to 13 per cent in 2007 (United States: 18 per cent; United Kingdom: 14 per cent). See S. Matthews (2011), “Trends in Top Incomes and Their Tax Policy Implications,” OECD Taxation Working Papers, No. 4, OECD Publishing, 2011. Bank of Canada, “Renewal of the Inflation-Control Target: Background Information – November 2011.” BIS central bankers’ speeches Even though desirable, eliminating the household sector’s net financial deficit will eventually leave a noticeable $50 billion gap in our economy over two years. This gap can only be sustainably filled by additional exports and business investment. But investment for what purpose and exports to where? The U.S. economy is experiencing the slowest recovery since the Great Depression as the repair of bank, household and government balance sheets slows growth. The only good news is that some progress is being made. U.S. banks have substantially increased their capital (common equity to total assets is up by more than 25 per cent). American households have recovered more than two-thirds of the $16 trillion fall in their net worth in the aftermath of the crisis, though we estimate that it will take several more years for households to make up the balance. Despite this, total debt in America has barely fallen from its peak of 250 per cent of GDP – a level last seen in the Great Depression. 5 This is because U.S. government debt has increased $4 for every $1 reduction of household debt. Such treading water will persist for some time since private domestic demand is still not sufficiently robust to outweigh an aggressive fiscal tightening. The Bank expects the U.S. expansion to average 2.5 per cent over the next few years (compared to 3 per cent in the decade prior to the crisis). Bottom line, the U.S. economy is not what it used to be. With less capital investment and more structural unemployment, even once the U.S. economy recovers its cyclical losses, the Bank estimates that it will remain over $1 trillion smaller in 2015 than we had projected prior to the crisis. Already, U.S. weakness means that Canadian exports are $30 billion lower than they would normally be at this stage in the cycle. Given our dependence on the U.S. market, our exports are still below their pre-recession peak. More broadly, with only 9 per cent of our exports going to the fast-growing emerging-market economies, our export performance has been the second worst in the G-20 over the past decade. Since 2000, our share of the world goods export market has fallen from about 4.5 per cent to 2.7 per cent. Some blame this on the persistent strength of the Canadian dollar. While there is some truth in that, it is not the most important reason. Over the past decade, our poor export performance has been explained two-thirds by market structure and one-third by competitiveness. Of the latter, about two-thirds is the currency while the rest is labour costs and productivity. 6 So, net, our strong currency explains only about 20 per cent of our poor export performance. In short, our underperformance prior to the crisis was more a reflection of who we traded with than how effectively we did it. We are overexposed to the United States and underexposed to faster-growing emerging markets. Recommended response To find and compete in new markets will require a concerted, multi-year effort of workers, firms and governments. This excludes the debt of the financial sector. Caveat: relative unit labour costs vis-à-vis the United States are a useful proxy to assess Canadian competitiveness. They might not tell the whole story, however. For instance, they might not adequately capture the further opening of world trade to emerging and developing economies (e.g., China joining WTO in 2001). BIS central bankers’ speeches First, we need an aggressive, emerging-market-focused trade strategy. That is why Canada is in a series of bilateral trade discussions with countries such as India, and will participate in the multilateral negotiations of the Trans-Pacific Partnership involving a number of Asian countries. It is not just that emerging-market economies now account for one-half of all import growth, but it is also that they are essential to secure our positions in global supply chains. Second, as the CAW has long recognised, the quality of our workforce is one of our greatest strengths – one in which we must continuously invest. With technology and trade transforming the workplace, the need to improve skills across the spectrum of work has never been greater. Both workers and management must continuously improve in order to take full advantage of new technology by making changes to design, marketing and processes. Third, we need to maintain an open and resilient financial system that at a minimum fulfills Ken’s wish not to be at the mercy of “global bankers...[who] have learned nothing from the last crisis.” 7 More broadly, we need a system that provides sustainably low-cost financing to businesses and consumers in the real economy so that we can grow output, jobs and incomes. Conclusion The global environment remains challenging. In recent months, there has been a widespread slowing of activity across advanced and emerging economies. Europe has slid back into recession and its crisis, while contained, remains acute. The U.S. economy continues to grow modestly, restrained by ongoing deleveraging and considerable uncertainty surrounding the fiscal cliff and the European situation. While these global headwinds are restraining Canadian economic activity and there are some short-term special factors weighing on growth, current underlying momentum is at a pace roughly in line with the growth of the economy’s production potential. Economic growth is expected to pick up through 2013. Consumption and business investment are expected to be the primary drivers of this moderate growth, reflecting very stimulative domestic financial conditions. While Canadian exports are projected to improve, they are likely to remain below their pre-recession peak until the beginning of 2014. This reflects weak foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. As the Bank noted in its most recent interest rate announcement, to the extent that the economic expansion in Canada continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term. The timing and degree of any such withdrawal will be weighed carefully against domestic and global economic developments. In a volatile global environment, we need to plan for the long term. We cannot devalue ourselves to prosperity or cut ourselves off from the world and hope to rely on ever-increasing borrowing by Canadian consumers. All of us – labour, business and governments – need to build on Canada’s advantages: • sound fiscal and monetary policy; • a resilient financial sector; • domestic inefficiencies that can be eliminated to boost employment and profit; Canadian Auto Workers (CWA) President Ken Lewenza speech to the CAW Council, p. 5, December 2, 2011. BIS central bankers’ speeches • under-exploited opportunities in the most dynamic economies in the world; and, most importantly, • a highly trained, dedicated and productive workforce, eager to learn new skills. At the FSB, we will concentrate on designing and implementing a series of financial reforms that ensures the financial system supports the real economy so that businesses can invest and hire and Canadian workers, including their leaders, can plan for the future with confidence. Thank you. 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 and Chairman of the Financial Stability Board, to the Spruce Meadows Round Table, Calgary, Alberta, 7 September 2012.
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Mark Carney: Dutch disease Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Spruce Meadows Round Table, Calgary, Alberta, 7 September 2012. * * * Introduction Some regard Canada’s wealth of natural resources as a blessing. Others see it as a curse. The latter look at the global commodity boom and make the grim diagnosis for Canada of “Dutch Disease.” 1 They dismiss the enormous benefits, including higher incomes and greater economic security, our bountiful natural resources can provide. Their argument goes as follows: record-high commodity prices have led to an appreciation of Canada’s exchange rate, which, in turn, is crowding out trade-sensitive sectors, particularly manufacturing. The disease is the notion that an ephemeral boom in one sector causes permanent losses in others, in a dynamic that is net harmful for the Canadian economy. While the tidiness of the argument is appealing and making commodities the scapegoat is tempting, the diagnosis is overly simplistic and, in the end, wrong. Canada’s economy is much more diverse and much better integrated than the Dutch Disease caricature. Numerous factors influence our currency and, most fundamentally, higher commodity prices are unambiguously good for Canada. That is not to trivialise the difficult structural adjustments that higher commodity prices can bring. Nor is it to suggest a purely laissez-faire response. Policy can help to minimise adjustment costs and maximise the benefits that arise from commodity booms, but like any treatment, it is more likely to be successful if the original diagnosis is correct. The global outlook The global economy is experiencing a broad-based deceleration from an already modest pace. A new normal for the United States The U.S. recovery is following the same dreary path of other advanced economies that have experienced financial crises. GDP growth has averaged just 2.2 per cent since the trough in 2009. Indeed, it is only with justified comparisons to the Great Depression that the success of the U.S. policy response is apparent. The only good news is that some progress on repairing balance sheets is being made. U.S. banks have substantially increased their capital (common equity to total assets is up by more than 25 per cent). American households have recovered more than two-thirds of the $16 trillion fall in their net worth in the aftermath of the crisis, though we estimate that it will take several more years for households to make up the balance. Despite this, total debt in America has barely fallen from its peak of 250 per cent of GDP – a level last seen in the Great Depression. This is because U.S. government debt has increased $4 for every $1 reduction of household debt. Such treading water will persist for some time The term “Dutch Disease” was first coined by The Economist in 1977 to describe the poor performance of the Dutch economy after a major natural gas discovery. BIS central bankers’ speeches since private domestic demand is still not sufficiently robust to outweigh an aggressive fiscal tightening. Bottom line, with less capital investment and more structural unemployment, the Bank estimates that the U.S. economy will remain over $1 trillion smaller in 2015 than we had projected prior to the crisis (Chart 1). Even in this room, that is a big number. An existential crisis in Europe Europe is stagnating with GDP still 2 per cent below its pre-crisis peak and private domestic demand a stunning 6 per cent below. A tough combination of fiscal austerity and structural adjustment will mean falling wages, high unemployment and tight credit conditions. As a consequence, Europe is unlikely to return to its pre-crisis level of GDP until a full seven years after the start of its last recession. Given ties of trade, finance and confidence, the rest of the world is feeling the effects. Europe’s contraction is driving banking losses and fiscal shortfalls. But these challenges are merely symptoms of an underlying sickness: a balance of payments crisis. To repay the creditors in the core, the debtors of the periphery must regain competitiveness. This will be neither easy nor quick. The burden cannot solely be on increasing unemployment and reducing wages in countries like Spain. An increase in German wages (and inflation) would ease the transition, especially if the structural reforms now under way across the deficit countries actually boost productivity. Important measures have been announced over the summer to begin to restore the single financial market, break the toxic links between banks and sovereigns and, potentially, help ensure that all euro-area countries can finance at more sustainable rates. All of these measures need to be fully implemented, not just announced. In that regard, the Bank very much welcomes yesterday’s announcement by the European Central Bank (ECB) of significant new measures to address convertibility risk and improve the transmission of monetary policy. However, it will take some time to restore market confidence, and it will take years for fiscal and structural adjustments to work. Moreover, the discussions over the federal institutions that may be ultimately required to support a durable monetary union are still in their infancy. Emerging-market economies In China and other emerging economies, the deceleration in growth in recent months has been greater than anticipated, reflecting past policy tightening, weaker external demand and the challenges of rebalancing to domestic sources of growth. Real GDP in China grew 7.6 per cent in the second quarter – the slowest pace in three years. Recent data suggest continued softening in this quarter. In part, this reflects a welcome policy-induced slowdown from the increasingly unsustainable rates of growth in recent years. With large vulnerabilities building in the housing sector, evidence of overinvestment increasing, and inflation above target, Chinese policy-makers appropriately responded by tightening monetary and macroprudential policies. Less anticipated has been the extent to which weaker external demand, especially from Europe, has weighed on export growth. More recently, in light of slowing growth and moderating price pressures, the People’s Bank of China has eased monetary policy and the fiscal stance has been relaxed. In both regards, authorities retain considerable additional policy flexibility. The Bank of Canada expects BIS central bankers’ speeches Chinese growth to average about 7.5 per cent over the next few years, materially below the unsustainable double digit rates seen since the trough of the crisis. The diagnosis Why we expect commodity prices to remain elevated Given the strains on global growth, commodity prices have fallen 13 per cent since their peak in April of last year and can be expected to remain volatile. Nonetheless, prices are still about 25 per cent above their longer-term averages in real terms. In fact, real prices for energy and metals have been well above their long-term averages for more than 7 years, and real food prices are now at their highest level in 35 years (Chart 2). Throughout the current, decade-long boom, the scale of price increases has been higher, and the range of affected commodities broader, than in previous upturns. Since 2002, prices for metals and grains have more than doubled, while crude oil prices almost quadrupled. The question is whether such strength will persist. The Bank’s view is that a large, sustained increase in demand is the primary driver of elevated prices. The breadth and durability of the commodity rally underscore this conclusion. Rapid urbanisation underpins this growth. Since 1990, the number of people living in cities in China and India has risen by roughly 500 million, the equivalent of housing the entire population of Canada every 18 months (Chart 3). Despite the current, sharp cyclical slowdowns in China and India, this secular process can be expected to continue for decades. So, even though history teaches that all booms are finite, with convergence to Western levels of consumption still a long way off, the demand for commodities can be expected to remain robust and prices elevated. In Canada, the impact of rising commodity prices has been reinforced by strong growth in the supply of some commodities. Oil is now our most important commodity by value (Chart 4), with its share rising over the past 15 years from 18 per cent to 46 per cent of total Canadian commodity production. The declining importance of manufacturing Coinciding with this period of elevated commodity prices, the share of the manufacturing sector in Canadian GDP has declined since the turn of the century from 18 per cent to around 11 per cent. For the promoters of Dutch Disease, this is the “a-ha” fact, with the coincidental relationship described as causal. With a broader view, however, it is evident that the decline in manufacturing is only partially in response to the rising exchange rate and, in fact, is part of a broad, secular trend across the advanced world (Chart 5). Major forces of globalisation and technological change have dispersed manufacturing activity across borders, increasingly concentrating the highest value-added stages of production in advanced economies. In 1970, Canada’s manufacturing-to-GDP ratio was 6 percentage points below the average of members of the Organisation for Economic Co-operation and Development (OECD). Today, it is 3 percentage points behind. Likewise, the share of jobs in manufacturing has declined, but not as steeply as it has in our commodity-importing neighbour to the south (Chart 6). Although the adjustment has been difficult, it has occurred over a longer period of time than the boom in commodity prices and, in general, Canada has not lost ground relative to other advanced economies. BIS central bankers’ speeches What drives the currency? The coincident strength of commodity prices and the Canadian dollar in recent years has been treated by some as prima facie evidence of Dutch Disease in Canada. But this diagnosis ignores the fact that the Canadian dollar is influenced by a diverse set of factors. Commodity prices do play a role. Canada is a net exporter of commodities while our main trading partner, the United States, is a net importer. This causes our respective terms of trade to move in opposite directions in response to commodity-price changes. As a result, the Canada-U.S. exchange rate tends to appreciate when global commodity prices rise (Chart 7). 2 But this is just the beginning of the story, accounting for about one-half of the appreciation of our currency over the past decade. Other factors also play important roles. Since 2002, the U.S. dollar has depreciated against many currencies, including those of both commodity exporters and importers. The Canadian dollar has appreciated against the U.S. dollar by an amount similar to that of the currencies of two major commodity importers, Japan and the euro area (Chart 8). Overall, the Bank estimates that about 40 per cent of the appreciation of the Canadian dollar since 2002 is due to the multilateral depreciation of the U.S. dollar. The balance of the appreciation reflects forces other than U.S.-dollar weakness and commodity prices. In particular, a variety of attributes make Canada an attractive investment destination, including our sound public finances, resilient financial system, and credible monetary policy. These strengths limit the downside risk associated with Canadian assets, making Canada a rare safe haven in a risky world. This status is reflected in the behaviour of Canadian 10-year yields, which tend to decline at the same time as risky assets such as global equity prices. This correlation suggests that money flows into Canadian bonds in response to increases in perceived risk. Indeed, by this measure, Canada’s safe-haven status is second only to the United States and the United Kingdom (Chart 9). This was not always the case. During the Great Moderation, this correlation was essentially zero (Chart 10). How commodity revenues affect our economy The symptoms we are seeing are not those of Dutch Disease but rather of structural changes in the global economy to which Canada must adjust. Although these changes create pressure, their overall impact is positive. Analysis using the Bank of Canada’s main projection model – the Terms-of-Trade Economic Model (ToTEM) – illustrates how different types of shocks to the supply and demand for commodities impact the Canadian economy. 3 Regardless of the cause of a commodity-price increase, Canada’s improved terms of trade cause income, wealth and GDP to rise (Chart 11). In all cases, the Canadian dollar appreciates, but its adverse impact on our non-commodity exports is partially offset by the fact that a stronger currency reduces the cost of productivity-enhancing machinery and equipment and imported inputs to production. R. Issa, R. Lafrance and J. Murray, “The Turning Black Tide: Energy Prices and the Canadian Dollar,” Working Paper No. 2006-29, Bank of Canada, 2006. ToTEM is well-suited to this type of analysis. As its name suggests, the model was designed to capture the effects of terms-of-trade movements on the Canadian economy. The model has been estimated using state-of-the-art techniques and it fits the key relationships in the data well. BIS central bankers’ speeches Consider three different cases that cause energy prices to rise 20 per cent, or roughly the increase that occurred between mid-2010 and 2011. When the source of the commodity-price increase is stronger U.S. demand, 4 the impact on Canadian GDP is greatest: just over a 3 per cent increase after five years, equivalent to about $57 billion. This is because the improvement in Canada’s terms of trade is strongly reinforced by greater demand for our non-commodity exports. In fact, this additional demand more than offsets the competitiveness losses in manufacturing and services stemming from higher wages, higher resource prices and a stronger dollar. This scenario is the commodity cycle as we used to know it. It is fast becoming a historical artefact. When, as is now the case, stronger demand from emerging Asia is the cause of the rise in energy prices, the net increase in GDP is about 1 per cent after five years, or one-third of the impact of the U.S. demand shock. This more muted response is because Canada has relatively little direct exposure to these export markets. Therefore, there is less additional demand to offset the competitiveness effects. Finally, an increase in commodity prices driven by a transitory reduction in commodity supply generates the smallest GDP benefits, about 0.2 per cent in the first year. In this case, the adverse impact of the appreciation is reinforced by the decline in economic activity in the rest of the world caused by the supply disruption. The run-up in oil prices in the past few weeks is an example of a commodity shock that provides only marginal benefit to Canada. In all three cases, the impact of increased economic activity in Canada on underlying inflation is largely offset by an appreciation of our exchange rate. This helps limit the direct impact of higher commodity prices on the prices all Canadians pay for food, gas and other commodity-intensive goods. When commodity prices increase, revenues from the resource sector spread through the Canadian economy via three channels: fiscal redistribution, especially by the federal government; personal wealth increases, through income and ownership of stock; and interprovincial trade. It is important to recognise that, for almost all the provinces, trade inside Canada has grown fast enough to offset a significant portion of the declines in international trade. Central Canada, for instance, suffered a real decline in international exports of $18 billion between 2002 and 2008, which was almost entirely offset by increases in interprovincial exports of $16 billion. Some of this reflects increased sales to Western Canada from Central Canadian machinery makers, primary metal producers, and chemical companies. Much of the gains in interprovincial trade volumes were in services rather than goods, which was where most of the declines in international exports occurred. Well-paid services, such as professional, mining, and financial services, play a significant role in increased trade between Central Canada and Alberta (Charts 12 and 13). Improving Canada’s economic health Recognising that higher commodity prices are good for the Canadian economy does not mean that policy has no role. The first objective of policy, of course, should be to do no harm. This brings me to the exchange rate. Modelled as an increase in U.S. potential output. BIS central bankers’ speeches Should the bank lean against the exchange rate? Some have argued that the Bank of Canada could improve welfare by leaning against commodity-driven movements in the nominal exchange rate. It is important to remember that with changes in the terms of trade, adjustments 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 levels of wages, output and prices. We can use ToTEM to simulate the effect of the Bank leaning against a commodity-driven exchange rate appreciation through a reduction to the policy rate. In the short run, stabilising the nominal exchange rate helps to support non-commodity exports as well as Canadian producers who face competition from imports. But, ultimately, this effort is futile. Over time, wages and inflation rise, causing the real exchange rate to appreciate. Non-resource exporters are faced with the same competitiveness challenges as they are today. Moreover, this leads to a sustained period of above-target inflation, which begins to unhinge inflation expectations. Monetary policy eventually has to tighten aggressively to restore price stability. The cost of this misadventure is lower output of about 1 per cent and higher volatility in inflation, output and employment than when the exchange rate is allowed to do its work (Chart 14). The outcome could be even worse if the Bank cannot quickly re-establish its credibility after betraying earlier commitments to Canadians. So, in general, the Bank does not intervene, except in exceptional circumstances, such as if there were signs of a serious near-term market breakdown or if extreme currency movements seriously threatened the conditions that support sustainable long-term growth of the Canadian economy. 5 The Bank does take the exchange rate into account in setting policy. The persistent strength of the Canadian dollar has been one of the reasons why monetary policy has been exceptionally accommodative for so long. Improve our exposure to countries driving the commodity cycle Economic activity in our major trading partners – particularly the United States – is no longer the main driver of commodity demand growth. Research at the Bank and elsewhere suggests that, while oil and metals prices have historically moved with the business cycle in the advanced world, this relationship has broken down over the past decade. In particular, industrial activity in emerging Asia now appears to be the dominant driver of oil-price movements (Chart 15). 6 Our reliance on the United States, which still takes nine times as many of Canada’s exports as fast-growing emerging-market economies, is an issue only if we expect U.S. underperformance relative to both history and the rest of the world to continue. Unfortunately, that is what we must expect for some time, as the United States goes through a difficult adjustment process. In this context, the only way to recover the beneficial correlation between commodity prices and demand for Canadian manufacturing exports is to diversify our export markets toward fast-growing emerging markets. That is one of the many reasons why Canada is pursuing an aggressive, emerging-market-focused trade strategy. Bank of Canada, “Intervention in the Foreign Exchange Market,” 2010. C. Cheung and S. Morin, “The Impact of Emerging Asia on Commodity Prices,” Working Paper No. 2007–55, Bank of Canada, 2007. BIS central bankers’ speeches Capture more value added in Canada Our challenge is to develop our commodities intelligently and sustainably. Eastern Canadian consumers are importing oil and paying the global price, at an average $35 premium to the price received by Western heavy oil producers over the past year. New energy infrastructure-pipelines and refineries could bring more of the benefits of the commodity boom to more of the country. Other new markets can be found at home. For example, as of November 2011, 255 Ontario firms were suppliers to the Canadian oil sands. 7 As well, Ontario’s exports of mining-related services to Alberta grew 44 per cent in the last year measured. Capturing more of the value added in commodity production, from energy to agriculture, remains a tremendous opportunity for all of Canada. We should also recognise that, in an era of high resource prices, better operating efficiency, improved resource management and products with a more sustainable environmental footprint make commercial and social sense. Advances in building energy efficiency, enhanced farm yields and power plant performance would pay immediate domestic dividends. However, the real prize may be in emerging markets, which contain an estimated 85 per cent of the resource productivity opportunities in the world. 8 Improve interprovincial mobility Crucial to capturing value added in Canada is ensuring that workers across the country can fully utilise their skills. A common complaint, especially in this province, is the lack of skilled labour. Research by the Bank of Canada and others shows there are implicit and explicit barriers created by provincial borders; for example, differences in occupational licensing, which deter interprovincial migration. 9 The New West Partnership Trade Agreement could be an important step to bringing down such barriers. For Canada as a whole, amendments agreed to in 2009 to the Agreement on Internal Trade (AIT) to encourage interprovincial mobility of regulated professionals and skilled trades have similar potential, if implemented. Increase skills to compete With technology and trade transforming the workplace, the need to improve skills across the spectrum of work has never been greater. First, we need to continue to improve the skills of our managers. Only one third of managers in Canada have a university degree, compared with almost half of American managers. 10 Second, we need to grow further and target better our already high level of post-secondary attainment. Even though Canada has the highest level of tertiary education in the OECD, only 60 per cent of our graduates work full-time, compared with the OECD average of 75 per cent. Further, 20 per cent of university-educated adults earn less than half the median wage. Quite simply, we need a lot more graduates in skilled trades as well as sciences, technology, engineering and math. STEM degree holders earn a $500,000 average lifetime wage Canadian Association of Petroleum Producers (CAPP). R. Dobbs, J. Oppenheim, F. Thompson, M. Brinkman and M. Zornes, “Resource Revolution: Meeting the World’s Energy, Materials, Food, and Water Needs,” McKinsey Global Institute Report, November 2011. D. Amirault, D. de Munnik and S. Miller, “What Drags and Drives Mobility: Explaining Canada’s Aggregate Migration Patterns,” Working Paper No. 2012–28, Bank of Canada, 2012. Institute for Competitiveness and Prosperity, “Management Matters,” 2009; N. Bloom, “Management and Productivity in Canada: What Does the Evidence Say?,” Industry Canada, Working Paper No. 2011–05. BIS central bankers’ speeches premium and can be up to five times less likely to be unemployed. 11 To develop our full resource potential and to compete in advanced manufacturing, our firms will increasingly need workers with such skills. Third, we need to continue to focus on skills upgrading and (re)training for existing workers to make up for historic underinvestment in these areas. 12 Sustained business investment The scale of the resource opportunity and the challenges of succeeding in a fiercely competitive global economy are some of the reasons why the Bank expects sustained business investment. Since the start of the recession, total Canadian business investment has been below average, while investment in machinery and equipment has been near average, in comparison with other postwar recoveries (Charts 16 and 17). With the strongest balance sheets on record (Chart 18) and benefiting from one of the most resilient financial systems in the world, the need for Canadian firms to build additional precautionary cash balances appears limited. There is a balance between prudence and action. Yes, there are immense uncertainties in the world economy, but we need to focus on what we can control. We can’t save the Euro, fix America’s fiscal cliff or restart their housing market. Should we just wait out a decade-long deleveraging process in the crisis economies? Should we lower our expectations? Or should we control our destiny by building on our strengths in the new global environment? Conclusion Building on our strengths requires that we respond appropriately to the opportunities the global transformation affords us. That starts with recognising that the strength of Canada’s resource sector is a reflection of success, not a harbinger of failure. The logic of Dutch Disease requires that we undo our successes in order to depreciate our currency. Taken to its natural conclusion, this logic dictates that we shut down the oil sands, abandon our resource wealth, have high and variable inflation, run large fiscal deficits and diminish our financial sector. Such actions would surely weaken the Canadian dollar, but they would also weaken Canada. In a world of elevated commodity prices, it is better to have them. Bank of Canada research shows that high commodity prices, regardless of the cause, are good for Canada. Rather than debate their utility, we should focus on how we can minimise the pain of the inevitable adjustment and maximise the benefits of our resource economy for all Canadians. R. Dobbs, A. Madgavkar, D. Barton, E. Labaye, J. Manyika, C. Roxburgh, S. Lund and S. Madhav, “The World at Work: Jobs, Pay, and Skills for 3.5 Billion People,” McKinsey Global Institute, June 2012. One third of Canadian workers (31 per cent) participate in job-related, non-formal training (compared with the OECD average of 28 per cent). But the number of hours spent in training is relatively low-the average Canadian worker spends 15 hours in job-related, non-formal training per year, compared with an OECD average of 18 hours. In Germany, the average is 26 hours. In Scandinavian countries, adults spend 35–40 hours per year in job-related, non-formal training. See OECD (2011), Education at a Glance 2011: OECD Indicators, OECD Publishing. 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 Timothy Lane, Deputy Governor of the Bank of Canada, to the CFA Society of Calgary, Calgary, Alberta, 25 September 2012.
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Timothy Lane: Financing commodities markets Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the CFA Society of Calgary, Calgary, Alberta, 25 September 2012. * * * Introduction Good afternoon. I want to thank the CFA Society of Calgary for inviting me to speak to you today. I would like to take this opportunity to share some thoughts on the role of the financial system in our natural resource economy. In particular, I would like to focus on the changing relationship between the financial system and commodities markets. Natural resources are of central importance to Canada’s economy and financial system, and nowhere is that more apparent than here in Calgary. The development of these natural resources has been powering much of Calgary’s – and Canada’s – recent economic growth. Natural resource industries – including farming, forestry, mining, oil and gas extraction and related industries – are a key element of the Canadian economy, accounting for roughly one fifth of our gross domestic product. 1 That share is roughly twice the share of natural resource industries in the United States economy and higher than in most other advanced economies. 2 Resources are an even more important feature of Canada’s international trade, accounting for roughly half of our exports. We all have a strong stake, therefore, in ensuring that these resources are developed wisely and sustainably for the benefit of all Canadians. Doing that requires several elements: an appropriate policy environment, flexible labour markets and a reliable transportation network. It also requires a sound and efficient financial system that meets the needs of the resource economy. The financial system is connected to resource development in two main ways. First, it channels the financing needed to develop those resources. Canada’s equity markets in particular are heavily weighted toward resources: the TSX Venture Exchange is one of the world’s primary listing destinations for resource firms, and even the Toronto Stock Exchange is sometimes referred to as “the world’s mining exchange.” Bank lending and other financing flows also play an important part. Many of you are directly involved in some aspect of this financing. Second, the financial system is linked with the commodities markets. Here, I mean the intricate web of global markets in which commodities are bought and sold, prices determined, and the producers and end-users of commodities hedge against unexpected movements in those prices. These markets are very important in determining the returns that Canadian producers earn for their output, as well as the risks they face. In my remarks today, I would like to address this second aspect: the commodities market and its nexus with the financial system. My focus is the key trends related to financial innovation, deleveraging and regulation. Natural resource industries include the following: agriculture, hunting, forestry and fishing; mining and oil and gas extraction; wood products; paper manufacturing; printing and related support activities; petroleum and coal products; chemicals, excluding pharmaceuticals; non-metallic mineral products; primary and fabricated metals; and utilities. J. Murray, “Commodity Prices: The Long and the Short of It,” speech to the Johnson/Shoyama Graduate School of Public Policy, Regina, Saskatchewan, 10 February 2011. BIS central bankers’ speeches Complex global commodities markets The commodities markets are complex in several ways. There are spot markets and forward transactions, as well as other derivatives contracts such as options. There are organized exchanges and over-the-counter markets. There are physical and financial aspects. Trading takes place in many different geographical locations and many different commodities and grades of those commodities are traded. There are also many players in these markets: producers; end-users; major commodity trading houses; the commodity trading operations of the large global investment banks; exchange-traded funds (ETFs); various institutional and individual investors and, in some cases, government agencies. So what makes these markets global? Arbitrage is the glue that binds together markets that are separated by distance and time, as well as markets for different but related products. Arbitrageurs take advantage of price differences, buying low and selling high, and thus driving those prices together. They can also take advantage of differences between physical and financial commodity markets, tying together prices across those markets. Various market-makers hold inventories and stand ready to buy and sell commodities, connecting suppliers and end-users. These arbitrage and market-making activities are often undertaken by the same firms and are difficult to disentangle. Of course, there are limits to the extent to which prices converge in global commodities markets. The recent behaviour of oil prices is a particularly telling example of these limits. Western Canadian crude oil has been selling at a deep and varying discount compared with the world price. This discount is due to the limitations of our transport network as well as differences in grade. As a result, Western Canadian producers of heavy oil have recently been obliged to sell their output at as much as $54 per barrel below the world price of oil – while Eastern Canadian consumers continue to pay the world price. 3 This illustrates the point that when prices in different parts of the global commodities market diverge, Canadians may not reap the full benefits of their natural resources. Commodity prices I’ve stressed that arbitrage and market-making are critical to tying global commodities markets together. These activities provide significant liquidity to commodities markets and, when they work properly, they also help bring commodity prices into line with the fundamentals of supply and demand – by which I mean, not just current supply and demand, but expectations of how supply and demand will evolve in the future. There is strong evidence that broad movements in commodity prices over the longer term indeed reflect these fundamentals at a global level. Beginning in the 1990s, the robust resource-intensive growth of emerging market economies (EMEs) has propelled commodity markets into a supercycle. The number of people living in cities in China and India has risen by roughly 500 million since 1990. In parallel, the global middle class has been growing by 70 million people each year. These trends are widely expected to continue, with profound ramifications for a broad range of commodities. 4 Of course, there have been significant variations around the upward trend in commodity prices. On average, commodity prices have declined over the past year, as the growth in emerging-market economies has been moderating. Nonetheless, commodity prices as a whole are still about 25 per cent above their historical averages in real terms. In particular, real prices for energy and metals have been well above their long-term averages for more World oil price refers to the price of Brent crude. M. Carney, “Dutch Disease,” speech to the Spruce Meadows Round Table, Calgary, Alberta, 7 September 2012. BIS central bankers’ speeches than seven years now, and real food prices are now at their highest level in 35 years (Chart 1). Financing commodities trading I have stressed the role of commodities markets – and in particular market-making and arbitrage – in tying together the global markets and bringing prices into line with fundamentals. These activities inevitably require financing – and the form of that financing has changed considerably over the past couple of decades. I would like to talk now about how that financing has changed and discuss the implications for the commodities markets and the financial system. There have been two countervailing trends: a strengthening of the links between the financial system and commodities markets during the decade or so before the 2008 global financial crisis, and an element of retrenchment and restructuring since then. Let me describe each of those trends in turn. A central element in the financing of commodities leading up to the 2008 crisis was the increasing participation of major global investment banks. Because of their access to wholesale funding markets, which provided them with cheaper funding than was available to other participants in commodity markets, the large banks became increasingly important in a range of commodity-related activities. They provided a large share of the lending to commodity dealers. They also themselves came to play a central role as dealers in over-the-counter derivatives markets in commodities. More recently, they have become more and more involved in the physical trading of commodities: holding physical inventories, making markets in commodities and even creating supply chains by providing shipping and commodity storage. In parallel, the globally active commodity trading houses assumed a large and expanding role. These institutions hold inventories of commodities, store them over time, move them around the world, and make markets in both physical commodities and their derivatives. As these trading houses grew, they played an increasingly important role in facilitating the trade in commodities. They are not financial institutions, but they do require large amounts of financing. Traditionally, this financing was mostly in the form of syndicated bank lending secured by their commodities inventories, but recently that financing model has been shifting, as I will discuss. Alongside the increasing role of these large institutions was the trend toward the “financialization” of commodities. Investors – both individuals and institutions such as pension funds and hedge funds – stepped up their interest in commodities (Chart 2). A combination of factors may have contributed to this trend. To some extent, investors may have been seeking higher returns associated with the commodity-price supercycle. They may also have sought to diversify their portfolios by including commodities as a distinct asset class. Whatever the reason, this movement of investors into commodities was facilitated by financial innovations – notably, the emergence of index funds and, later, a variety of exchange-traded funds (Chart 3). More recently, high-frequency trading has also become a feature of commodity markets, as it has in financial markets. These developments together helped turn commodities into increasingly liquid financial assets, accessible to a wider range of investors. In turn, the flood of investment funds into commodities helped spur further innovation. There is no clear evidence that this trend toward greater financialization has been a significant determinant of the overall level of commodity prices. As I have already discussed, the preponderance of evidence indicates instead that commodity prices have been driven by fundamentals – primarily by rising demand from EMEs. Research – including work at the BIS central bankers’ speeches Bank of Canada – that looked for a possible link between prices and the volume of financial activity in commodities markets showed that it is difficult to identify such a relationship. 5 It is possible that, under some circumstances, financial forces may have amplified price movements that were primarily driven by other forces and may thus have contributed to volatility – for example, by exaggerating spikes in oil prices. In contrast, some have argued that financialization has improved the efficiency of commodities markets. But no simple pattern emerges from the evidence. There is still a range of views on whether financial forces have, on the whole, contributed to or dampened volatility in commodity prices. 6 It does appear, however, that financialization has been associated with closer ties between commodity markets and financial markets. One indication of this relationship is the greater correlation between short-run movements in commodity prices and the prices of other risky assets, including stock price indexes and currencies (Chart 4). In part, this no doubt reflects common macroeconomic factors driving the prices of a number of risky assets – particularly, changing market assessments of the prospects for global growth. But it is also plausible that such movements partly reflect investors’ changing perceptions of risk and, in some cases, changes in the availability of liquid financing for their investment positions. (Ironically, the increasing correlation between commodity prices and the prices of other assets such as equities diminishes the benefits of diversification that investors sought by investing in commodities in the first place.) Developments in the wake of the crisis I have been describing stronger links between the financial system and commodity markets during the decade or two prior to the global financial crisis that came to a head in 2008. But in the wake of that crisis, the global financial system has been undergoing a sea change. This in turn has introduced further important changes to the financing of commodities trading. Deleveraging has been the most significant trend in the global financial system since the crisis – one that is likely to continue for some time to come. 7 Particularly pronounced in the United States and Europe, the deleveraging process is being driven partly by the need for financial institutions to restore their balance sheets after the losses they incurred during the crisis and the ensuing worldwide recession. It also reflects the tightening of financial regulations to make the system more resilient, with a view to preventing a new crisis. Under the terms of Basel III, the minimum amount of capital that banks must hold has increased by about five times. The largest, most complex firms must hold even more. 8 Finally, deleveraging also reflects the shrinking of the shadow banking system – the complex web of securitized products, non-bank financial institutions, funding markets and other markets that created large amounts of leverage in some countries in the years preceding the crisis. On the whole, this deleveraging is a welcome correction – both by financial institutions and the regulatory authorities – to the excessive leverage that had built up in the global financial system before the crisis. As this process is completed, it should result in a more resilient global financial system. But it is also protracted and painful, with pervasive effects on the R. Alquist and O. Gervais, “The Role of Financial Speculation in Driving the Price of Crude Oil,” Discussion Paper No. 2011-6, Bank of Canada, 2011. See also: Report of the G-20 Study Group on Commodities, under the chairmanship of Hiroshi Nakaso, Trade Finance Experts Groups (November 2011). A 2009 report by IOSCO also called for greater transparency in commodities markets, in part with a view to reducing the risk of market manipulation. See “Task Force Report on Commodity Futures Markets: Report to the G-20,” Technical Committee of the International Organization of Securities Commissions, March 2009. M. Carney, “Growth in the Age of Deleveraging,” speech to the Empire Club of Canada/Canadian Club of Toronto, Toronto, Ontario, 12 December 2011. T. Macklem, “Raising the House of Reform,” speech to the Rotman Institute for International Business, Toronto, Ontario, 7 February 2012. BIS central bankers’ speeches global financial system and economy. Indeed, deleveraging by financial institutions as well as by households and governments is the main force that is keeping the global economy on its current path of gradual and unbalanced growth. How has this deleveraging affected commodities trading? Banks have been pulling back from the commodities sector, both in terms of their lending to commodities traders and their own market-making and proprietary trading activities. Until recently, European banks provided up to 80 per cent of the financing for the trading of commodities worldwide. But, as those banks have had to repair their balance sheets, they have scaled back their lending, bringing their share down to about 50 per cent. To some extent, U.S. and Asian banks as well as banks in the Middle East have stepped into the breach: they have increased their share of financing for commodity houses. However, in the current climate, that financing is more limited and has come at an increasing cost. For banks doing business in the United States, the anticipated impact of the Dodd-Frank legislation on their commodity trading operations has been an important additional reason for curtailing these operations. The involvement of banks in the financial trading of commodities, including derivatives, has declined and some have pulled out of the sector altogether. We have also seen a marked decline in the commodity assets that banks have under management. As banks have been scaling back their commodities-related lending, they have scaled back their commodities operations – for instance, reducing bonuses and remuneration for their commodity specialists. One area, however, in which some banks have been maintaining, or even expanding, their activities is in the physical side of the commodity business, increasing holdings of physical products and investments in the supply chain. These activities are more akin to those traditionally being undertaken by the commodity trading houses themselves. Recently, investors have also grown more cautious, pulling back their commodity-related investments. Commodity-related assets under management have declined, reducing another financing flow into commodities trading (Chart 5). As banks have scaled back their involvement in commodities, commodity trading houses have grown in importance and have changed their funding models. Some commodity companies have begun tapping the capital markets for the first time. Sales of investment-grade bonds by commodity companies are up 90 per cent over last year, and commodity-linked junk bonds have risen by an estimated 40 per cent so far this year. As commodity traders have increasingly been funding themselves directly through the capital markets, they have been making greater use of innovative financing tools. Some have used hybrid or convertible structures, and (particularly in Asia) have been making broader use of collateralized financing. In Europe, some banks are using structured trade credit insurance as a means of deleveraging while also remaining active in the commodity trade in emerging markets. 9 Another development that partially reflects these changes in financing conditions is the wave of mergers and acquisitions that has been sweeping the commodity-trading sector. In a number of cases, the logic of these transactions is to bring trading houses and producers together. That’s not a new business model – indeed, the oil majors have had their trading operations for many years. But it is an increasingly attractive one in the current climate of dwindling bank financing for commodities. The latter shift has also been encouraged by regulation: many European countries allow such insurance to count as regulatory capital under the Basel III rules. BIS central bankers’ speeches Implications So far, I have given you a thumbnail sketch of the changing trends in the financing of commodities markets. But why do these developments matter for the world economy, and particularly for Canada? Here, I would like briefly to highlight three sets of issues. First, there may be implications for the pricing of commodities. As I have stressed, the broad trends in commodity prices is determined by the fundamentals of supply and demand – notably the long-term growth in demand from Asian emerging-market economies. But the functioning of the markets in which commodities are traded has the potential to influence pricing in several ways. The flows of financing for commodity trading activities can affect the liquidity and efficiency of these markets and thus the extent to which prices reflect those fundamentals. As well, the financialization of commodities has the potential to affect the degree of short-term volatility of the markets. Although it is too early to assess the implications of the recent changes in financing patterns I have been describing, these developments bear watching. A second set of issues pertains to systemic risk. In particular, the large trading houses, together with the physical trading operations of some large investment banks, are playing an increasingly prominent role in a number of commodity markets. This raises the possibility that some of these institutions are becoming systemically important. Just as the 2008 financial crisis revealed the need to assess the systemic importance of institutions that play a central role in particular financial markets, we should be asking the same questions about institutions that are interconnected with various commodity markets. Here, I have two general questions in mind: Could the failure of one of the large trading houses cause serious disruption in the commodities markets in which it played a market-making role? And, could the losses that a trading house incurs through the positions it has taken in commodities have significant knock-on effects on the financial system? We are far from having answers to those questions, but they need to be addressed. Third, commodities trading can potentially be an important link between the financial system and the real economy. With the financialization of commodities, financial system stress has the potential to affect commodities markets. Commodities markets, in turn, have an important influence on the economic outlook of a commodity-rich country such as Canada. Moreover, movements in commodity prices may pose risks to the financial institutions that channel funding to commodity-trading activities. While it is possible that the recent trends toward deleveraging are actually diminishing the links between the financial system and commodities markets, this is a development that it will take time to assess. Conclusion Allow me to conclude. A sound and efficient financial system – both in Canada and globally – is essential for developing natural resources for the benefit of all Canadians. As I have discussed, the relationship between the financial system and the commodity markets has strengthened over the past couple of decades. However, in the wake of the global financial crisis, new trends have emerged that are associated with the broad trend toward deleveraging by financial institutions. The overall level of commodity prices is driven by supply and demand, particularly the rising demand from emerging-market economies. But financialization may have important implications for the short-term volatility of prices and their co-movements with the prices of other financial assets; for systemic risk; and for the channels through which stresses in the financial system can affect the real economy and vice versa. Given the importance of commodities to the Canadian economy, the Bank of Canada is monitoring these developments, with a view to safeguarding the economic well-being of all Canadians. 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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, to the Winnipeg Chamber of Commerce, Winnipeg, Manitoba, 4 October 2012.
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Tiff Macklem: A measure of work Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, to the Winnipeg Chamber of Commerce, Winnipeg, Manitoba, 4 October 2012. * * * Introduction Good morning and thank you for the invitation to speak here today. I am pleased to be in Winnipeg, a city that is boldly preparing for the job market of the future. From programs that help new immigrants, to connecting job opportunities with older workers, Winnipeg and Manitoba are providing innovative solutions to the challenge of matching workers with jobs and jobs with workers. My remarks today will also focus on jobs. The mandate of the Bank of Canada is 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.” We learned from bitter experience in the 1970s that the best way for the Bank to fulfill this mandate is to keep inflation low, stable, and predictable. Since 1991 – now more than 20 years ago – this objective has been formalized with an inflation target, and since 1995 the target has been to achieve an annual rate of inflation of 2 per cent, as measured by the consumer price index (CPI). The target is reviewed every five years and was most recently renewed in 2011.1 With low, stable and predictable inflation, Canadians can have confidence in the value of their money. That’s one less thing they have to worry about. But there is more. Controlling inflation is also a means to an end. Low, stable and predictable inflation paves the way for solid economic growth and a well-functioning, stable and healthy labour market. Having a job is one of the most important measures of an individual’s economic and financial welfare. How well, then, has our inflation-targeting monetary policy succeeded in mitigating fluctuations in the level of employment? How have the benefits been distributed across different segments of the labour market? How has monetary policy supported a betterfunctioning or more efficient labour market? And what is the health of our labour market today and its prognosis looking ahead? I am going to address these questions in three parts. In Part 1, I will scan back over the past four decades, comparing labour market performance in Canada before and after the introduction of inflation targeting. In Part 2, I will focus on labour market outcomes through the most recent cycle of recession and recovery. And in Part 3, I will comment on the challenges and opportunities that lie ahead. Labour markets before and after inflation targeting A picture of inflation is worth a thousand words. As depicted in Chart 1, the change in the behaviour of inflation since the adoption of inflation targeting is stark. Both the average level and the variability of inflation have fallen dramatically.2 Since 1991, inflation in Canada has averaged 2 per cent, as measured by the CPI, and its standard deviation has fallen by roughly two-thirds, compared with the 1970s and 1980s (Table 1). Bank of Canada, “Renewal of the Inflation-Control Target: Background Information – November 2011.” D. Longworth, “Inflation and the Macroeconomy: Changes from the 1980s to the 1990s,” Bank of Canada Review, Spring 2002. BIS central bankers’ speeches This low, stable and predictable inflation has been associated with more stable economic growth in Canada and lower and less-variable unemployment. The average rate of unemployment has fallen, and fluctuations in unemployment as measured by its standard deviation have been reduced by about one-third. Importantly, more stable growth since we began inflation targeting has reduced the cyclical fluctuations in unemployment for workers in all age and educational categories. Moreover, fortuitously, the most vulnerable workers have benefited the most (Table 2). Unemployment rates for younger workers and those with less education are typically more variable than those for well-educated prime-age workers. And it is these same groups that have experienced the largest decline in variability with the adoption of inflation targeting. So the benefits of greater stability have been shared across the workforce, and workers with the largest fluctuations have seen the greatest improvement. Better labour market outcomes over the past 20 years have also been accompanied by improved labour market efficiency. The Beveridge Curve measures how well labour markets are matching job vacancies with workers looking for jobs (Chart 2).The closer the Beveridge Curve is to its origin (zero vacancies and unemployment), the more efficient the labour market. As shown, the curve in the 1980s (blue line) has a higher level of unemployment for a given level of vacancies than the curve in the 1990s and early 2000s (red line).3 Of course, improved labour market performance reflects a broad spectrum of public policies and private sector initiatives, from employment insurance to education and training, active labour market programs, procurement practices, and licensing and residency requirements for employment. Nonetheless, there is no doubt that better monetary policy has been an important factor. The improved inflation environment has allowed consumers and businesses to manage their finances with greater certainty about the future purchasing power of their savings and income. Interest rates have also been lower and less variable in both nominal and real terms across a range of maturities. And by working to stabilize inflation, monetary policy has helped dampen economic cycles and mitigate fluctuations in employment. In addition, there is direct evidence that low, stable and predictable inflation has improved the efficiency of labour markets by eliminating inflation uncertainty as an important friction in wage bargaining and allowing wage changes to provide genuine signals to market participants regarding the demand for and the supply of workers. As inflation has become more stable and predictable, the variability of aggregate wages has declined. The standard deviation of labour income per worker has dropped by about 45 per cent. At the same time, with less uncertainty about inflation, the distribution of wage changes has narrowed. In the unionized private sector, the standard deviation across individual wage settlements fell by about a third, improving the efficiency of the labour market and the perception of fairness around wage setting. In addition, since 1991, the average duration of labour contracts has almost doubled, from about 20 months to 39 months, and there has been less need for cost-of-living allowances (COLAs) in wage contracts (Chart 3). The number of labour contracts with COLA clauses has declined from 21 per cent to less than 5 per cent. Longer contracts and less disagreement about future inflation have also meant fewer strikes. The hours lost to strikes peaked in the early-to-mid-1970s when inflation was at double-digit levels and uncertainty was high. Since then, the time lost has fallen sharply (Chart 4). Total hours lost to strikes fell by 66 per cent from the pre-inflation-targeting era to today. With Statistics Canada stopped collecting data on vacancies in 2003, since the widespread adoption of the Internet has changed the way vacancies are advertised. BIS central bankers’ speeches inflation low, stable and predictable, workers and firms are spending less time and fewer resources negotiating and striking, and more time creating value and income. Recession and recovery Let’s fast forward from the past 40 years to the past five. Many workers in Canada felt the severe impact of the global financial crisis that began in 2007. When the United States fell into recession, Canada was affected through trade, financial, and confidence channels. But with our well-regulated financial system, a credible monetary policy framework and a record of fiscal prudence, monetary and fiscal stimulus proved highly effective in dampening the cycle and spurring the recovery. Employment in Canada recovered quickly from the recession compared with previous recessions or the experiences of other G-7 countries (Chart 5). Some 430,000 jobs were lost in Canada during the recession. All of them have since been recouped and another 339,000 have been created. This stands in stark contrast to the situation in the United States, where 8.8 million jobs were lost and only about half have been regained (Chart 6). The U.S. unemployment rate currently stands close to 1 percentage point above Canada’s and a full 2 percentage points higher when measured on a like-for-like basis. And more than 40 per cent of unemployed U.S. workers have been out of work for more than six months, compared with only 18 per cent of workers in Canada (Chart 7). Long-term unemployment is particularly worrisome because workers who are out of a job for extended periods lose valuable job skills, making them less employable and more likely to give up looking for work. Indeed, labour market participation in the United States has declined by 2.5 percentage points more than it has in Canada (Chart 8). Some commentators have suggested that while the Canadian economy has created more jobs, fewer manufacturing jobs and more service sector jobs have meant fewer high-paying full-time jobs. True, the share of service sector jobs has risen while manufacturing has declined. This is part of a longer-term trend. The share of employment in manufacturing has declined steadily across all advanced economies and Canada’s experience is about average. But the rest of the argument is myth. Since the trough, the vast majority of the new jobs created are full-time and in the private sector (Chart 9). And more than 90 per cent of them are in industries that pay average or above-average wages (Table 3). These new positions are in such fields as construction, utilities, health care and professional, scientific, and technical services. Gauging the tightness of the labour market is a key element in assessing how close the economy is operating relative to its capacity, which, in turn, is an important indicator of inflationary pressures. With a relatively quick recovery in employment, much of the slack in the labour market following the 2009 recession has been taken up. Nevertheless, most indicators suggest that some slack remains (Chart 10). The unemployment rate remains above its pre-crisis decade average. The duration of unemployment also remains above its pre-recession average and the number of people working part-time who would prefer to work full-time has come down only slowly. And the behaviour of wages is not pointing to generalized excess demand for labour. Wage growth has been modest (Chart 11). The labour market is an important component of the Bank’s assessment of the amount of excess supply in the economy. We continue to monitor the full range of labour market indicators, together with other relevant information, very closely as we seek to achieve the 2 per cent inflation target. To the extent that the economic expansion continues and the excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy BIS central bankers’ speeches stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term. The timing and degree of any such withdrawal will be weighed carefully against domestic and global economic developments. The future labour market In the five years since the start of the financial crisis, the most significant labour market challenge has been creating enough good jobs for workers. Over the next five years, the most important challenge is more likely to be finding enough good workers for jobs. Even with some slack remaining in labour markets, firms are reporting – with increased frequency – difficulty in attracting suitable labour. Our own Business Outlook Survey indicates that labour shortages have gradually moved up across the country. And in the latest survey of small and medium-sized businesses by the Canadian Federation of Independent Business, “Shortage of skilled labour” has moved ahead of “Insufficient customer demand” as the top business constraint facing their members.4 Looking ahead, Canada’s demographic trends will compound the scarcity of labour.5 We are getting older, living longer and having fewer children. That means more workers retiring and fewer people to replace them. This will put upward pressure on wages and lead to adjustments to the composition and the nature of the labour force. For firms, attracting talent while retaining relevant expertise and institutional knowledge will be more challenging. Confronting this challenge requires working on three margins: expanding the labour force; utilizing it more efficiently; and increasing labour productivity. Let me address each of these in turn. Expanding the labour force Several segments of the labour force have potential for greater labour market participation. Let me highlight three. First, older individuals may be enticed to stay longer in the workforce. Indeed, this is already happening. The labour market participation rate of workers over 50 has increased by more than 12 percentage points since 1995. This is being facilitated by the fact that Canadians are, on average, healthier than ever and that more jobs today are knowledge-based. Corporate policies and technology that support more flexible working arrangements, together with targeted training and employment information programs, will be needed to further improve labour market access for aging workers. On this issue, I know I’m preaching to the converted here in Manitoba. The innovative ThirdQuarter project initiated by you and your colleagues in the Manitoba Chambers of Commerce, which is helping to match employers with experienced workers over 50, is the sort of creative thinking we need to address our demographic challenges.6 Second – and this point is particularly important here in Manitoba – we must redouble our efforts to address unemployment among Aboriginal people. Their unemployment rate is above the Canadian average and their participation rate is lower. Moreover, the Aboriginal population is growing faster and has a higher proportion of young people than the overall “September 2012 Results of SME Business Outlook Survey,” Business Barometer, Canadian Federation of Independent Business, 3 October 2012. J. Boivin, “Aging Gracefully: Canada’s Inevitable Demographic Shift” (speech to the Economic Club of Canada, Toronto, 4 April 2012). For details on the ThirdQuarter program, see: www.thirdquarter.ca. BIS central bankers’ speeches Canadian population. Improving the access to jobs for Aboriginal people is the right thing to do for many reasons. The demographic squeeze is just one more reason. This all points to the importance of public and private initiatives to successfully launch the careers of more Aboriginal people in the workforce. And third, immigration is critical for the growth of the labour force. Without immigration, the Canadian population would be expected to shrink over the next 50 years. And here again, Manitoba is serving as an example for others. When the federal government introduced Provincial Nominee Programs to influence the regional distribution of immigrants and allow the provinces to address local labour needs, Manitoba took the lead in using the program.7 As a result, although foreign migrants to Canada are more naturally attracted to our largest urban centres, Winnipeg, and Manitoba more broadly, punch above their weight at attracting foreign migrants. But attracting foreign migrants is only the first step. We must also tear down the barriers that keep educated and skilled immigrants from contributing to their full potential. Recent federal government initiatives to support improvements in the recognition of foreign credentials are a welcome step. Employers also have a role to play in revising their own hiring practices. Improving the efficiency of the labour market The second margin is to get more of the labour force working. This means ensuring that workers have the skills employers are seeking, which speaks to the importance of ongoing dialogue between industry, labour and institutions for postsecondary education. It also means getting workers to where the jobs are being created. Migration has always been an important adjustment mechanism for the Canadian economy and we see signs that workers are, in fact, becoming more mobile. Recent Bank research suggests that long travel distances across Canada may not be as great a barrier to labour mobility as they once were.8 Over the past decade and a half, people have moved from regions with excess labour to those with the tightest labour markets, leading to the convergence of unemployment, participation and employment rates (Chart 12). By 2011, the gap or disparity in employment rates across the 10 provinces was at its lowest level since 1976 (as far back as data are available) and not very different from the dispersion of employment rates across the United States. Nonetheless, barriers to interprovincial migration that are not related to distance, such as differences in occupational licensing, remain an obstacle. The New West Partnership Trade Agreement could be an important step to bringing down such barriers, as could the 2009 amendments to the Agreement on Internal Trade (AIT). Improving productivity The final margin is improving labour productivity. Indeed, over the longer term, productivity growth has the greatest potential to boost prosperity. Regrettably, it is also where our performance has been the worst.9 T. Carter, M. Pandey and J. Townsend, “The Manitoba Provincial Nominee Program: Attraction, Integration and Retention of Immigrants,” IRPP Study No. 10, October 2010. D. Amirault, D. de Munnik and S. Miller, “What Drags and Drives Mobility: Explaining Canada’s Aggregate Migration Patterns,” Working Paper No. 2012–28, Bank of Canada, 2012. T. Macklem, “Canada’s Competitive Imperative: Investing in Productivity Gains” (speech to Productivity Alberta, Edmonton, 1 February, 2011). BIS central bankers’ speeches Productivity growth in Canada has ranged from disappointing to dismal. Since 2001, Canada’s productivity growth has slowed to historically low rates and has languished well below U.S. rates. From 2000 to 2011, productivity growth in the Canadian business sector averaged 1 per cent annually, compared with 2.4 per cent in the United States. As a result, Canadian firms today are only 78 per cent as productive as U.S. firms. While some aspects of Canada’s productivity performance remain a puzzle, there are a number of clear facts that point to obvious remedies. Workers that have more and better machinery and equipment (M&E) to work with, particularly information and communication technology (ICT), are more productive. And Canadian businesses on average invest less in M&E and ICT than their U.S. counterparts. Between 1987 and 2010, Canadian investment per worker in M&E and ICT averaged 76 per cent and 58 per cent, respectively, of that invested in the United States. By 2010, on average, Canadian workers had only about half as much M&E and ICT capital stock to work with as their U.S. counterparts. With a persistently strong Canadian dollar, a widening competitiveness gap, low interest rates, strong balance sheets and increasing labour scarcity on the horizon, the imperative for Canadian businesses to invest in M&E has rarely been more compelling. Recent investment performance has been solid but not spectacular. We must do better than solid. In addition to more M&E, workers need better skills. Canada has a well-educated workforce that ranks favourably when it comes to primary and post-secondary education. However, compared with U.S. firms, Canadian firms lag in the employment of workers with advanced degrees, in the educational attainment of their managers, and in on-the-job training. Canadian firms hire fewer employees with PhDs and other postgraduate degrees, especially in the sciences. Only one-third of managers in Canada have a university degree, compared with almost half of American managers.10 And only about a third of adult workers receive jobrelated education and professional development training in Canada, compared with half in the United States.11 Canadian firms need to put more emphasis on skills when hiring and invest more in training to enhance the skills of existing workers. There are also other aspects to strengthening productivity growth, including research and development, innovation and developing new markets but I must conclude. Conclusion The health of the Canadian labour market is vastly improved since the 1970s and 1980s. Low, stable and predictable inflation has been an important ingredient in this transformation. And Canadians can continue to rely on the Bank of Canada to deliver on its inflation target and, in doing so, support a better functioning and more stable labour market. Canada’s labour market has recovered from the recession better than most, and continues to expand at a modest pace. Most of the jobs created since the end of the recession have been full-time and in sectors that pay above-average wages. Much of the slack in the labour market has been taken up, and firms are increasingly facing difficulty in finding suitable labour. Nevertheless, some slack remains and can be expected to persist in the near term. Institute for Competitiveness & Prosperity, “Management Matters”, Working Paper No. 12, 2009; N. Bloom, “Management and Productivity in Canada: What Does the Evidence Say?,” Industry Canada, Working Paper No. 2011–05, 2011. M. Goldenberg, “Employer Investment in Workplace Learning in Canada,” Discussion Paper for the Canadian Council on Learning, prepared by Canadian Policy Research Networks, 14 September 2006. BIS central bankers’ speeches But looking ahead, as the slack is taken up and demographic trends slow the growth of the labour force, continued labour-market health will depend increasingly on reducing barriers to work, connecting workers with jobs, and facilitating a more mobile and more productive workforce. Thank you. Charts and tables 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 and Chairman of the Financial Stability Board, to the Vancouver Island Economic Alliance, Nanaimo, British Columbia, 15 October 2012.
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Mark Carney: Uncertainty and the global recovery Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Vancouver Island Economic Alliance, Nanaimo, British Columbia, 15 October 2012. * * * Introduction It is a pleasure to be in Nanaimo at the Vancouver Island Economic Summit. With British Columbia serving as Canada’s gateway to Asia, you are well aware of the interconnectedness of the global economy. To the benefit of billions of people, goods, capital and ideas flow across borders as never before. Unfortunately, so too does angst. This is my topic today. While the “Great Recession” is over, what has followed is an unfamiliar process of repairing public and private balance sheets across advanced economies. The depth and duration of this deleveraging are unclear. Deleveraging is holding back the global recovery and laying bare distinct challenges in different parts of the world. The euro area is stagnating as it struggles with an underlying balance-of-payments crisis. The United States is at the edge of a fiscal cliff. China and other emerging markets are trying to sustain rapid growth amid weak demand in their traditional export markets. There is a synchronous slowdown under way in the global economy. This past weekend in Tokyo, when the International Monetary Fund (IMF) marked down its growth forecast, no region or major economy was spared. Further, the IMF warned that downside risks have risen. 1 Against this background, it is not surprising that uncertainty over the global economic outlook is high. It is being reinforced by concerns over how policy-makers will address these challenges. This combined uncertainty is further complicating the recovery, prompting firms and consumers to retrench. There is some evidence of this dynamic here in Canada as businesses feel the weight of darkening global prospects. While I will not be able to dispel all of these concerns today, my objective is to explain how policy-makers are addressing some uncertainties and to put some others in their proper context. Uncertainty and Its Impact It is only human to respond to uncertainty with caution. Faced with a highly volatile environment, households shy away from spending on big-ticket items such as houses or cars, and firms put off making large capital investments and hiring new workers. The effect on business investment can be particularly significant. This is because uncertainty increases the value of waiting for new information when firms decide whether to undertake big projects, leading them to reduce current investment. 2 That uncertainty has such real effects is clear. However, the precise degree of uncertainty at any given point in time and its impact on economic activity are themselves uncertain. See the IMF’s World Economic Outlook (WEO), “Coping with High Debt and Sluggish Growth,” October 2012, which also includes a discussion of uncertainty. Available at http://www.imf.org/external/pubs/ft/ weo/2012/02/index.htm. B. Bernanke, “Irreversibility, Uncertainty, and Cyclical Investment,” The Quarterly Journal of Economics 98, no.1 (1983): 85–106. BIS central bankers’ speeches According to standard measures of financial market volatility, such as the VIX, or implied volatilities from options prices in other asset classes, the current environment does not appear to be particularly uncertain. 3 In fact, many of these measures are at post-crisis lows. The comfort offered by these market-based measures may be misleading. For one, they may be importantly influenced by the extraordinary liquidity provided by central banks. This liquidity has supported financial markets and thereby provided insurance against downside risks. The dampening effect of central bank action may not persist if economic fundamentals do not ultimately improve, meaning that there could be a discontinuous shift in volatility at some point in the future. Moreover, trading volumes across asset classes have generally been low in recent months, as many market participants with large cash holdings sit on the sidelines. Paralysis, not confidence, may better account for the observed declines in actual and implied volatility. This apparent lack of conviction in markets can itself be considered a sign of unusual levels of uncertainty. Other indicators, such as surveys of households and businesses, tend to be more consistent with what many feel. For instance, the most recent Small Business Problems & Priorities survey of the U.S. National Federation of Independent Business finds that “uncertainty over economic conditions” ranked second in their list of most “critical” problems. “Uncertainty over government actions” was fourth. Another index of economic policy uncertainty for the United States, constructed by researchers at Stanford, has shown a clear upward trend in recent years. 4 They estimate that the rise in policy uncertainty between 2006 and 2011 reduced the level of real U.S. GDP by approximately 3 per cent and was associated with a loss of about 2.3 million jobs. Using a similar methodology, Bank of Canada researchers estimate that the increase in policy uncertainty observed since the reintensification of the euro-area crisis late last year may have lowered the level of euro-area GDP by roughly 1 per cent. Analytically, there is a clear question of causality here – does uncertainty cause slower growth or is it the other way around, with difficult economic times inducing greater qualms about the future? Surely it works both ways. Thus, the current combination of economic weakness and heightened uncertainty may be forming a vicious circle in the global economy. That there is uncertainty about how the global economy will respond to an unprecedented period of deleveraging is not surprising. More troubling is the apparent uncertainty about the stance and perceived effectiveness of economic policy. The question is what can policy-makers do about it? Europe Let me start with Europe. The euro-area economy is stagnating, with GDP still 2 per cent below its pre-crisis peak and private domestic demand a stunning 6 per cent below. The causes of this underperformance are deep-seated. An adverse feedback loop between weakening economic activity and sovereign and banking sector vulnerabilities has made the task of fiscal consolidation even more difficult. The VIX refers to the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P500 index options. It represents a market estimate of short-term stock market volatility. S. Baker, N. Bloom and S. Davis, “Uncertainty and the Economy,” Policy Review 175 (2012). The index incorporates newspaper coverage of policy-related economic uncertainty, the number of tax code provisions set to expire in future years and the extent of disagreement among economic forecasters. BIS central bankers’ speeches Europe’s banking losses and fiscal shortfalls are merely symptoms of a more serious underlying illness – a balance-of-payments crisis. To repay the creditors of Europe’s core economies, the debtors of peripheral economies must regain competitiveness. Although there has been some progress, this process will be neither easy nor quick. There are two ways to address the uncertainties plaguing Europe. First, Europe is often said to be suffering an existential crisis – meaning that the very existence of the euro is being questioned. Recent actions, particularly by the European Central Bank (ECB), are now directly addressing this risk. The ECB has recently introduced a new program – the Outright Monetary Transactions (OMT) program – that is specifically designed to eliminate the risk of euro redenomination. Simply put, subject to certain conditions, the ECB will act to ensure that yields on any particular euro-area country’s short-term government bonds should reflect only the credit risk of that sovereign, not the risk that the country will leave the euro. 5 By lowering yields in this manner, the ECB will substantially improve the transmission of monetary policy, and thereby increase the prospects for economic recovery in Europe. Second, it would be helpful if European authorities would reframe the expectations of citizens and market participants regarding the time horizon over which European monetary union will be refounded. You are no doubt aware that there has been a seemingly endless series of crisis summits held about the euro in recent years – nineteen meetings at the Leader level in the past two years. Although there has been important progress, there was never any chance any one meeting could solve the issue. For the euro area to be a viable currency union, several reforms over a 3 to 5 year period will be required. These include: • necessary institutional changes, including a banking union; • a closer fiscal union, including a fiscal transfer system and some form of mutualisation of sovereign debt; • reforms to enhance labour market flexibility and mobility, as well as measures to promote competition and productivity in product markets; and • steady reductions in (cyclically adjusted) budgetary deficits. By reframing expectations to a realistic timeline, and ensuring that any financing assistance program for countries is sufficient for this period, European authorities could arrest the cycle of crisis summits, and thereby reduce policy uncertainty. The slowdown in China In emerging economies, growth has slowed at a greater-than-anticipated rate in recent months. In China, real GDP grew 7.6 per cent in the second quarter, its slowest pace in three years, and recent data suggest continued softening in the third quarter. The slowdown in China’s growth reflects two broad influences. First, external demand for China’s exports has weakened, owing in particular to the recession in Europe, China’s largest trading partner. Second, past policy actions in China are having an effect. With large vulnerabilities building in the housing sector, increasing evidence of overinvestment, and inflation above target, Under the OMT, the ECB will be able to purchase sovereign debt with maturities of 1 to 3 years without limit. Participation in the program is restricted to member countries that undergo a European Financial Stability Facility/European Stability Mechanism program. This condition is critical, as “strict and effective conditionality” is needed to ensure that countries continue to undertake required reforms. BIS central bankers’ speeches policy-makers appropriately tightened monetary and macroprudential policies once the economy shook off the effects of the 2008–09 global crisis. Given these excesses, the reduction in China’s growth to more sustainable rates is welcome. However, recent signs that the slowdown in the Chinese economy may become too intense have prompted authorities to unwind some of the past policy tightening. This process has begun, with notable fiscal stimulus measures announced recently. Nonetheless, there remains significant uncertainty over how quickly China can adjust its growth model. With the limits of an export-led growth strategy now obvious, rebalancing to encourage domestic sources of growth is needed. Yet prior rounds of stimulus appeared to stoke already very high levels of residential and business fixed investment, rather than consumption, which remains exceptionally low. The risk is that, once again, the right stimulus will end up in the wrong places. For outside observers, the uncertainty surrounding the economic outlook in China is compounded by the difficulty in obtaining reliable information regarding the extent to which the economy has already slowed. That said, it is important to put China’s recent performance in context. The Bank of Canada expects growth in China’s GDP to average about 7.5 per cent over the next few years. While this is substantially below the unsustainable double-digit rates seen in recent years, it is still considerable. In fact, 7.5 per cent real growth in Chinese GDP in 2012 will add roughly $800 billion to the global economy, an amount equivalent (in real terms) to the 14 per cent rate of growth in China in 2007, and approximately twice the dollar value of U.S. growth this year. The U.S. outlook The U.S. recovery remains modest, consistent with the experience of other advanced economies that have faced financial crises. Although the fiscal challenges continue to loom, the recovery appears to be on a somewhat surer footing. American households have recovered more than two-thirds of the $16 trillion in net worth lost in the aftermath of the crisis. While it will take several more years to make up the balance, the process of household deleveraging appears well advanced, particularly now that the U.S. housing market is beginning to recover. In addition, major U.S. banks have substantially increased their capital, and U.S. corporate balance sheets are very strong. Despite this progress, aggregate debt across all sectors of the U.S. economy has not budged from its peak of about 250 per cent of GDP. The burden of deleveraging in the United States has, in a sense, been transferred from the private to the public sector. It is clear that the U.S. public debt burden needs to be reined in over the medium term. Precisely how is less obvious. Existing legislation incorporates automatic tax increases and spending cuts, set to kick in next January, amounting to roughly 4 per cent of GDP – the so-called “fiscal cliff.” If authorities do not change these provisions, this massive fiscal drag will likely push the U.S. economy back into recession next year. That is not what we expect, but like others, we cannot be sure. There is evidence that uncertainty surrounding the resolution of the fiscal cliff issue is already having an adverse impact. While the general tone of the U.S. data has improved slightly of late and financial markets have held up, high-frequency indicators related to U.S. business investment – where one would expect to see the greatest impact of uncertainty – have weakened. For example, new orders for capital goods have fallen sharply, declining by 26 per cent over the most recent three months. This is by far the weakest result since the end of the recession. BIS central bankers’ speeches The Bank assumes that the United States will, in the end, step back from the fiscal cliff. Even with that assumption in place, the Bank projected in its July Monetary Policy Report that fiscal tightening in the United States will remove 1 percentage point from U.S. growth in 2012, and 1.5 percentage points in each of 2013 and 2014. Under such a scenario, the near-term hit to the economy is largely avoided, but the need for fiscal consolidation persists – as indeed it does under any plausible scenario. A clear, consistent and committed medium-term U.S. fiscal plan, one that demonstrates how this consolidation will be achieved, would be helpful in mitigating a major uncertainty that would otherwise endure. More positively, recent Fed actions have actually reduced uncertainty. Specifically, the Fed has provided greater certainty by indicating that its policy rate could be expected to remain at extremely low levels until mid-2015. It has also provided more certainty with respect to its reaction function, linking future unconventional monetary policy to substantial improvements in the outlook for the U.S. labour market. In addition, the Fed has indicated that it will leave highly accommodative policy in place “for a considerable time after the economic recovery strengthens.” If conditions were to deteriorate and further easing were required, the U.S. central bank could provide even greater certainty with further refinements, such as precise numerical targets and a time frame for achieving these targets. The Fed did not just sharpen communication, it also announced its intention to purchase $40 billion in securities per month – a strategy nicknamed “QE3.” As with previous rounds of monetary stimulus, QE3 can be expected to support the American recovery, both directly by lowering interest rates, and more broadly, through the so-called portfolio-balance effect. This channel tends to lift asset prices and reduce the value of the U.S. dollar. The overall impact of QE3 for Canada is estimated to be modestly positive, reflecting its supportive implications for U.S. and global activity and the resulting boost to commodity prices. What does all this mean for Canada? Elevated global uncertainty is holding back global economic growth and, thus, the demand for Canadian exports. In addition, there is some evidence that global uncertainty is affecting domestic activity. According to the Bank’s most recent quarterly Business Outlook Survey, released this morning, Canadian firms have become more circumspect about new capital expenditures and less inclined to hire new workers. 6 In this environment of slow global economic growth and uncertainty about demand, firms have also tempered their sales expectations for the next 12 months. However, while Canada’s economy is being affected by the global angst, the key areas of uncertainty abroad are all points of justifiable confidence here at home. Canada’s public finances are sound. Monetary policy is clear and credible. Canada’s financial system showed itself to be among the most resilient in the world through the crisis. Since then, it has strengthened further. One thing Canadian businesses can expect is that their financial system will be there if times get tough again. In this uncertain world, then, Canada is rightly viewed as an attractive investment destination. This is having an important effect on Canadian financial conditions. Capital inflows are tending to push up the value of our dollar, thus acting as a headwind to the Canadian economy. However, foreign capital is also tending to push domestic asset prices up and longer-term interest rates down, which has a supportive effect on domestic growth. The Bank takes all of this into account when setting monetary policy. Bank of Canada, Business Outlook Survey, Autumn 2012. BIS central bankers’ speeches The Bank provides as much certainty as it can in the conduct of monetary policy. While we obviously cannot determine events over which we have no control, we can be transparent about what we expect and how we would react to different scenarios. That includes being clear about the role of monetary policy in supporting financial stability in Canada. For example, if we were to lean against emerging imbalances in household debt, we would clearly declare we are doing so and indicate how long we expect it would take for inflation to return to the 2 per cent target. 7 Conclusion Let me conclude. Eighty years ago, faced with a more dire set of economic circumstances than we are today, Franklin D. Roosevelt famously told Americans that “the only thing we have to fear is fear itself.” But this is not the Great Depression. The IMF expects the global economy to grow by more than 3 per cent this year and next, or just under the average of the past 10 years. What we face now is better described as uncertainty rather than fear. Nonetheless, the spirit of FDR’s comment applies – we must take care not to allow uncertainty to dominate our actions, letting profitable opportunities slip away and, more generally, compounding the very real, but still manageable, challenges facing the global economy. At times of extreme economic and policy uncertainty, it pays to be quick and bold, as the central banks of the United States, the United Kingdom, and the euro area have been. As Canadians, we need to focus on what we can control. We can’t save the euro, fix America’s fiscal cliff or restart the U.S. housing market. Should we just wait out a decade-long deleveraging process in the crisis economies? Should we lower our expectations? Or should we control our destiny by building on our strengths in the new global environment? We can improve Canada’s low productivity growth and sharpen our focus on emerging markets. And we can continue to invest in our greatest resource – our people. Against this backdrop, next week’s Monetary Policy Report will provide a full update on the Bank’s outlook for economic growth and inflation in Canada. It will take into account the impact of the uncertainty that I have been discussing today. The Bank will take whatever action is appropriate to achieve the 2 per cent CPI inflation target over the medium term. That certainty is our contribution to ensuring that Canadians can invest and plan with confidence. Bank of Canada, “Renewal of the Inflation-Control Target: Background Information – November 2011.” 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, 24 October 2012.
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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, 24 October 2012. * * * 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 unfolded broadly as the Bank projected in its July MPR. Growth has slowed in all major regions. The economic expansion in the United States is progressing at a gradual pace. Europe is in recession and recent indicators point to a continued contraction. • In China and other major emerging economies, growth has slowed somewhat more than expected. However, there are signs of stabilization around current growth rates. • Notwithstanding the slowdown in global economic activity, prices for oil and other commodities produced in Canada have, on average, increased in recent months. Global financial conditions have improved, supported by aggressive policy actions of major central banks. Sentiment, though, remains fragile. • In Canada, while global headwinds continue to restrain economic activity, domestic factors are supporting a moderate expansion. Following the recent period of belowpotential growth, the economy is expected to pick up and return to full capacity by the end of 2013. • The Bank continues to project that the expansion will be driven mainly by growth in consumption and business investment, reflecting in part very stimulative domestic financial conditions. • Housing activity is expected to decline from historically high levels. The household debt burden is expected to rise further before stabilizing by the end of the projection horizon. • There are upside and downside risks around the evolution of household imbalances. Residential investment could regain momentum, thereby reinforcing existing imbalances. Conversely, continuing high household debt levels could lead to a sharper-than-expected deceleration in household spending. In this context, Canadian authorities are co-operating closely to monitor the financial situation of the household sector, and are responding appropriately. • Canadian exports are projected to pick up gradually, but remain below their prerecession peak until the first half of 2014, reflecting weak foreign demand and ongoing competitiveness challenges. These challenges include the persistent strength of the Canadian dollar, which is being influenced by safe haven flows and spillovers from global monetary policy. • After taking into account revisions to the National Accounts, which had the effect of raising measured growth for this year, the Bank now projects that the economy will grow by 2.2 per cent in 2012. Going forward, we expect growth of 2.3 per cent in 2013 and 2.4 per cent in 2014. • Core inflation has been lower than expected in recent months. This reflects somewhat softer prices across a wide range of goods and services. Core inflation is expected to increase gradually over coming quarters, reaching 2 per cent by the middle of 2013 as the economy gradually absorbs the current small degree of slack, BIS central bankers’ speeches the growth of labour compensation remains moderate and inflation expectations stay well-anchored. • Total CPI inflation has fallen noticeably below the 2 per cent target, as expected. It is projected to return to target by the end of 2013, somewhat later than previously anticipated. • The inflation outlook in Canada is subject to significant risks. The Bank’s projection assumes that authorities in Europe are able to contain the ongoing crisis, and that the U.S. fiscal cliff will be avoided. – The three main upside risks relate to the possibility of higher global inflationary pressures, stronger Canadian exports and renewed momentum in Canadian residential investment. – The three main downside risks relate to the European crisis, weaker demand for Canadian exports and the possibility that growth in Canadian household spending could be weaker. • Overall, the Bank judges that the risks to Canada’s inflation outlook are roughly balanced over the projection period. • Reflecting all of these factors, the Bank yesterday maintained the target for the overnight rate at 1 per cent. Over time, some modest withdrawal of monetary policy stimulus will likely be required, consistent with achieving the 2 per cent inflation target. The timing and degree of any such withdrawal will be weighed carefully against global and domestic developments, including the evolution of imbalances in the household sector. 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 and Chairman of the Financial Stability Board, before the House of Commons Standing Committee on Finance, Ottawa, Ontario, 30 October 2012.
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Mark Carney: Opening Statement before the House of Commons Standing Committee on Finance Opening statement by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, before the House of Commons Standing Committee on Finance, Ottawa, Ontario, 30 October 2012. * * * Good afternoon. 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 unfolded broadly as the Bank projected in its July MPR. Growth has slowed in all major regions. The economic expansion in the United States is progressing at a gradual pace. Europe is in recession and recent indicators point to a continued contraction. • In China and other major emerging economies, growth has slowed somewhat more than expected. However, there are signs of stabilization around current growth rates. • Notwithstanding the slowdown in global economic activity, prices for oil and other commodities produced in Canada have, on average, increased in recent months. Global financial conditions have improved, supported by aggressive policy actions of major central banks. Sentiment, though, remains fragile. • In Canada, while global headwinds continue to restrain economic activity, domestic factors are supporting a moderate expansion. Following the recent period of belowpotential growth, the economy is expected to pick up and return to full capacity by the end of 2013. • The Bank continues to project that the expansion will be driven mainly by growth in consumption and business investment, reflecting in part very stimulative domestic financial conditions. • Housing activity is expected to decline from historically high levels. The household debt burden is expected to rise further before stabilizing by the end of the projection horizon. • There are upside and downside risks around the evolution of household imbalances. Residential investment could regain momentum, thereby reinforcing existing imbalances. Conversely, continuing high household debt levels could lead to a sharper-than-expected deceleration in household spending. In this context, Canadian authorities are co-operating closely to monitor the financial situation of the household sector, and are responding appropriately. • Canadian exports are projected to pick up gradually, but remain below their prerecession peak until the first half of 2014, reflecting weak foreign demand and ongoing competitiveness challenges. These challenges include the persistent strength of the Canadian dollar, which is being influenced by safe haven flows and spillovers from global monetary policy. • After taking into account revisions to the National Accounts, which had the effect of raising measured growth for this year, the Bank now projects that the economy will grow by 2.2 per cent in 2012. Going forward, we expect growth of 2.3 per cent in 2013 and 2.4 per cent in 2014. • Core inflation has been lower than expected in recent months. This reflects somewhat softer prices across a wide range of goods and services. Core inflation is BIS central bankers’ speeches expected to increase gradually over coming quarters, reaching 2 per cent by the middle of 2013 as the economy gradually absorbs the current small degree of slack, the growth of labour compensation remains moderate and inflation expectations stay well-anchored. • Total CPI inflation has fallen noticeably below the 2 per cent target, as expected. It is projected to return to target by the end of 2013, somewhat later than previously anticipated. • The inflation outlook in Canada is subject to significant risks. The Bank’s projection assumes that authorities in Europe are able to contain the ongoing crisis, and that the U.S. fiscal cliff will be avoided. – The three main upside risks relate to the possibility of higher global inflationary pressures, stronger Canadian exports and renewed momentum in Canadian residential investment. – The three main downside risks relate to the European crisis, weaker demand for Canadian exports and the possibility that growth in Canadian household spending could be weaker. • Overall, the Bank judges that the risks to Canada’s inflation outlook are roughly balanced over the projection period. • Reflecting all of these factors, on 23 October, the Bank maintained the target for the overnight rate at 1 per cent. Over time, some modest withdrawal of monetary policy stimulus will likely be required, consistent with achieving the 2 per cent inflation target. The timing and degree of any such withdrawal will be weighed carefully against global and domestic developments, including the evolution of imbalances in the household sector. 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 and Chairman of the Financial Stability Board, at the Canadian War Museum, Ottawa, Ontario, 7 November 2012.
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Mark Carney: Release of the $20 bank note Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the Canadian War Museum, Ottawa, Ontario, 7 November 2012. * * * On behalf of the Bank of Canada, I want to thank the Canadian War Museum for hosting this event. Visitors of all ages leave this building better informed about Canada’s history and our contributions to struggles the world over. Visitors also leave humbled, as they learn of the enormous sacrifices of men and women who have given so much for their country. The new $20 polymer bank note – which begins today to make its way into banks, stores, and wallets across the country – features the Canadian National Vimy Memorial. It is altogether fitting that this bank note – the most widely used denomination – would remind Canadians of the Battle of Vimy Ridge, which was so pivotal in our history. While the imagery of the new $20 bill reminds us of the past, in all other respects, the bank note itself represents the future. Safer, cheaper, greener – these notes are the product of innovative technology and Canadian ingenuity. There is no other currency like them. The unique combination of transparency, holography and other sophisticated security elements makes them a world first. State-of-the-art security features ensure we are staying ahead of counterfeiters and providing Canadians with bank notes they can use with complete confidence. The bank notes last longer, at least 2.5 times longer than those made with cotton-based paper. This makes them more economical and their environmental footprint smaller. After they are removed from circulation, they will be recycled here in Canada. As with the $50 and $100 bank notes, which were introduced into circulation over the past year, the Bank of Canada has worked with financial institutions and retailers to ease the transition from the old to the new so that the businesses that handle cash can readily adapt. When people hold their first polymer $20, I hope they will take a moment to consider more than its face value; that they will consider the image of the Canadian National Vimy Memorial and reflect upon and remember the sacrifices of those who have come before us. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Canadian Club of Montréal, Montréal, Quebec, 8 November 2012.
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Mark Carney: Some current issues in financial reform Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Canadian Club of Montréal, Montréal, Quebec, 8 November 2012. * * * Introduction I am pleased to be in Montréal today, having just returned from meetings of G-20 Finance Ministers and Central Bank Governors in Mexico City. While we covered many important topics, a substantial part of the agenda focused on assessing the progress of global financial sector reform. This is my topic today – providing you with an update of what has been achieved, and what remains to be done. The importance of these efforts should be obvious. Five years ago, the complete loss of confidence in private finance could only be arrested by comprehensive backstops from the world’s richest economies. In the ensuing recession, the global economy lost more than $4 trillion in output and almost 28 million jobs. Here in Canada, we learned that keeping our own house in order is not enough. Even with our strong and well-functioning financial system, the Canadian economy suffered a decline of almost $70 billion in GDP and lost more than 430,000 jobs. While we have more than recouped all those losses, our economy continues to be held back by the weak global recovery. That is why it is important for all Canadians that all countries follow through on these reforms. To address the question of how G-20 countries are doing, I will concentrate on three issues: • Are banks safer today? • Have we ended the phenomenon of institutions that are “too big to fail”? • Is shadow banking a force for good or ill? Let me turn to the first. Are banks safer? Banking system frailties were cruelly exposed by the crisis. Many people remember the pivotal moment when Lehman Brothers collapsed, but that was only one example of a widespread failure of banking models across the advanced economies. In 2008, major banks in the United States, the United Kingdom, Germany, France, Ireland, Switzerland, the Netherlands and Belgium either failed or were rescued by the state. Gallingly, on the eve of their collapse, every bank boasted of capital levels well in excess of the standards of the time. How was this possible? In some cases, “off-balance-sheet” exposures proved to be very much the responsibility of the banks when push came to shove. In others, balance sheets were stuffed with supposedly risk-free structured products that turned out to be lethally toxic. In the end, the old risk-based capital standards were both too weak and too porous. This proved fatal when banks’ loss absorbency was called upon. BIS central bankers’ speeches Building capital So it should be a surprise to no one that when building a more resilient system, the G-20 started with strengthening the bank capital regime. With the new Basel III rules, the quantity and quality of bank capital are being improved immensely: • The minimum requirement for common equity will rise from 2 per cent to 4.5 per cent under Basel III, and to 7 per cent when the new capital conservation buffer is added. This more than triples the required amount of high-quality capital. • A new countercyclical capital buffer will compel banks to further increase capital by up to 2.5 percentage points if threats of system-wide disruptions are rising. • For those banks whose failure would pose a risk to the global financial system, even more capital will be required. By 2019, these institutions will face a capital surcharge that rises from 1 per cent to 2.5 per cent of risk-weighted assets. In addition, the new rules will bring more exposures on balance sheets and require more capital against riskier activities (e.g., trading activities and securitisations). For example, capital required for the trading book will be tripled. The effective increase in capital is even larger once the tougher definition of capital is factored in. In total, the largest banks will have to hold at least seven times as much capital as before the crisis. While these measures are scheduled to be implemented over the next six years, banks are not waiting to rebuild confidence in their creditworthiness. Since the end of 2007, major banks in the United States and Europe have increased their common equity capital by $575 billion and their common equity capital ratios by 25 per cent. Based on the new rules, the average capital ratio of internationally active banks at the beginning of this year already stood at 7.7 per cent.1 In general, the industry can meet the new targets through earnings retention over the transition period. For example, for all large banks to reach the Basel III Tier 1 common equity target ratio by January 2019, they need to raise an amount about equal to their aggregate post-tax profits last year. Canadian banks are setting the pace. Since the end of 2007, the major Canadian banks have increased their common equity capital by 70 per cent, or $67 billion. All major Canadian banks are expected to meet the stringent 2019 Basel III requirements by next January, as specified by the Office of the Superintendent of Financial Institutions (OSFI). Reducing leverage In an ideal world, regulators would accurately measure the riskiness of banks’ assets when setting leverage. But who lives in a world where risks are known with certainty and can be measured with precision? Therefore, as a backstop to the inherent imperfections of a risk-based capital framework, a simple, but effective, leverage ratio has been imported from Canada into the global standard. The leverage ratio sets a cap on how many assets a bank can hold for each dollar of equity. It protects the system from risks we might think are low but in fact are not. 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 Based on the Basel III definition. See Basel Committee on Banking Supervision, “Results of the Basel III Monitoring Exercise as of 31 December 2011,” 20 September 2012, Table 2. The average capital ratio assumes full implementation of the new capital regulations, including all deductions. BIS central bankers’ speeches ratio. Elsewhere, leverage soared, in some cases doubling or tripling, while risk-adjusted measures remained stable. 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. Belt and suspenders The belt and suspenders approach of the capital and leverage ratios establishes two tests for the maximum amount of assets that financial institutions may hold relative to equity. An issue is which of these should bind first. If the leverage ratio does, banks will load up on riskier assets and push assets off their balance sheets in ways that satisfy accountants but not, ultimately, creditors. That is why a complex risk-weighted test is also necessary, and should be calibrated to bind before the leverage ratio in normal circumstances. Banks are safer as a result of this combined approach. But much more is required. We need to ensure consistent implementation. That is why the Financial Stability Board (FSB) just released a review of implementation in major jurisdictions. This review identified some deficiencies that will need to be addressed. The FSB and the G-20 will continue to use such transparency and peer pressure to ensure a level playing field. Of course, bank resilience is a function of much more than just capital. It also requires better risk management and improved governance. I will conclude later with some comments on how the totality of FSB reforms will encourage just that. Have we ended too-big-to-fail? The measures taken to date have lowered the probability of failure, but since failures will still happen, their impact must be reduced. In particular, we must address, once and for all, the unfairness of a system that privatises gains and socialises losses. By restoring capitalism to the capitalists, discipline in the system will increase and, with time, systemic risks will be reduced. In addition, the knowledge that major firms in markets far away can fail, without meaningful consequences at home, will restore confidence in an open global system. The cost of too-big-to-fail In addition to the public cost of the bailouts, there is the less-transparent and ongoing implicit subsidy. Large banks enjoy lower borrowing costs owing to direct support and implicit government guarantees. This subsidy effectively saved the 20 largest global banks $70 billion per year prior to the crisis, equivalent to 20 per cent of their profits.2 Moreover, the moral hazard problems associated with implicit public support may amplify risk taking, reduce market discipline, create competitive distortions, and further increase the probability of distress. What are we doing about it? To eliminate those costs on taxpayers and to promote market discipline, G-20 countries are taking several steps. A recent study by the International Monetary Fund finds that this implicit public guarantee effectively lowered the borrowing costs of banks in 14 advanced countries by approximately 60 basis points in 2007. The Bank of England estimates that, between 2002 and 2007, this was equivalent to about $70 billion per annum for the 20 largest global banks BIS central bankers’ speeches First, the FSB has identified those banks that are systemically important at the global level, based on size, complexity and interconnectedness with other aspects of the financial system.3 There are no Canadian banks on the current list. Second, to address the systemic and moral hazard risks associated with these systemically important financial institutions (SIFIs), the FSB has developed a range of measures, known as the Key Attributes.4 When implemented, these will help to ensure that any financial institution can be resolved without severe disruption to the financial system and without exposing the taxpayer to the risk of loss. Under the Key Attributes, bondholders, shareholders and management – rather than taxpayers – will have to bear the brunt of losses as a result of a new bail-in power in all G-20 member countries. Authorities will have the ability to convert some private debt to new equity in order to recapitalise, and share the losses of, a failing institution. The knowledge that this could happen should enhance market discipline of private creditors who previously enjoyed a free ride at the expense of taxpayers. In addition, each global SIFI must have mandatory recovery and resolution plans and resolvability assessments, as well as a cross-border co-operation agreement between relevant authorities. Further, member countries will complete specific plans by mid-2013 to recover or, if necessary, resolve these global SIFIs. Finally, each SIFI should be subject to more intense and effective supervision.5 Other systemic financial firms While these measures are being implemented, the FSB is working to extend this framework to other systemic financial firms, including domestic systemically important banks, global insurance companies, non-banks and core financial market infrastructure. In particular, the FSB and the G-20 have agreed to a principles-based approach to regulating domestic systemically important banks (D-SIBs) that complements the framework for global systemically important banks (G-SIBs) and provides for national discretion in the way that systemic importance is assessed and policy tools are applied. In Canada, OSFI will make these determinations. As countries implement their D-SIB frameworks, the frameworks will be subject to peer review to preserve a level playing field and ensure compatibility with the G-SIB framework. More progress required While we have made solid progress, it is not clear yet that too-big-to-fail has been ended. For example, credit-rating agencies continue to boost their ratings of major banks by a factor that recognises implied government support. This boost has increased since the crisis, meaning that the implicit subsidy of taxpayers to large banks may have grown tenfold by some estimates.6 Despite the proclamations of G-20 leaders, investors seem to think governments will once again blink when faced with a failing large bank. In part, this reflects the need to legislate, not merely propose. But it may also underscore the need for further measures, and to articulate clearly plans to resolve each systemic institution. These may include improving the effectiveness of cross-border agreements for handling a failure, and in my view, clearly The FSB has recently updated the list of global systemically important banks, reducing the number of such banks by one overall, from 29 to 28, as two banks have been added and three banks removed from the list. FSB, “Key Attributes of Effective Resolution Regimes for Financial Institutions,” October, 2011. See “Increasing the Intensity and Effectiveness of SIFI Supervision,” a progress report of the FSB to the G-20 Ministers and Governors, released on 1 November 2012. A. Haldane, “On Being the Right Size,” a speech to the Institute of Economic Affairs’ 22nd Annual Series, the 2012 Beesley Lectures at the Institute of Directors, 25 October 2012. BIS central bankers’ speeches identifying bail-inable securities, requiring a minimum amount of them, and publishing a presumptive path for resolution. This week, in Mexico City, we agreed to redouble our efforts on these fronts. The FSB will assess whether we have ended too-big-to-fail at the St. Petersburg Summit next September and I am confident the G-20 will agree on any further steps to do so if required. The G-20 is resolute in its intention to end too-big-to-fail. Is shadow banking a force for good or ill? There are valid concerns that as authorities take measures to make the traditional banking system safer, we will push risk into the shadow banking sector. That is one reason why the FSB has launched, and the G-20 endorsed, a comprehensive reform of the oversight and regulation of shadow banking. Shadow banking is best described as credit intermediation involving entities and activities (fully or partially) outside the regular banking system. When this intermediation is conducted appropriately, it is a valuable alternative to bank funding that supports real economic activity. But experience from the crisis demonstrates that non-bank entities and transactions can operate on a large scale in ways that create bank-like risks to financial stability. Like banks, the shadow banking system can be vulnerable to “runs,” thereby amplifying systemic risk. It can feed booms during surges in confidence and magnify busts when confidence evaporates. For example, in a dynamic that fed the U.S. housing bubble, the value of structured investment vehicles (SIVs) tripled in the three years to 2007, and credit default swaps grew sixfold. Following the sudden reappraisal of the creditworthiness of these instruments, assetbacked commercial paper (ABCP) markets froze, SIVs failed, and money market funds experienced runs. The feedback to the regulated sector was immediate and devastating. Money market mutual funds pulled short-term funding from the banking sector. Other core financial markets, such as repo and over-the-counter derivatives markets, seized up. Virtually all American investment banks and many commercial banks could not roll over their funding positions. During this time, the Canadian non-bank ABCP sector – a classic shadow banking activity – also collapsed.7 Only the Herculean efforts of the public and private sector through the Montréal Accord could resolve this debacle. We should all hope that the lessons of these sorry episodes remain fresh in the minds of investors, banks and regulators for some time. However, experience suggests it would be foolish to rely on memory alone. That is why the FSB and G-20 are acting. Our core objective is to address bank-like risks to financial stability that emerge outside the regular banking system. At the same time, we want to preserve sustainable non-bank financing models that do not pose such risks but provide needed competition to banks and credit to the real economy. As a result, the FSB’s approach, outlined this week in Mexico, is proportionate to financial stability risks and starts with those activities that were sources of problems during the crisis. It also provides a process for monitoring the shadow banking system so that any rapidly growing new activities that pose bank-like risks can be identified early and, where needed, addressed. These vehicles were part of a complex chain that transformed short-term investments in commercial paper into long-term loans. As confidence that this paper could be rolled over faltered, there was indiscriminate selling of structured assets. BIS central bankers’ speeches There are five work streams to address vulnerabilities. They seek to: • mitigate the spillovers between the regular and the shadow banking systems; • reduce the susceptibility of money market funds to runs; • mitigate systemic risks posed by other shadow banking entities; • align the incentives in the securitisation process to prevent excessive leverage in the financial system; and • dampen risks and procyclical incentives associated with secured financing contracts such as repos and securities lending. Initial recommendations will be released shortly for public consultation. Detailed assessments of the impact of these measures on financial system resilience and economic growth will be conducted. Based on these findings, the FSB will deliver a final integrated set of recommendations for approval by the G-20 leaders at the St. Petersburg Summit. The ultimate goal of these reforms is to turn risky shadow banking into resilient market-based financing. The latter is an essential and valuable part of the modern financial system. Getting the market to work I have spent some time today outlining an ambitious and necessary set of measures that will significantly improve the safety and the stability of the financial system. The unique nature of financial firms and the enormous costs of failure require regulation and supervision to supplement internal governance of banks and market discipline.8 The new Basel capital and liquidity rules will encourage better risk management. New FSB compensation standards will better align incentives of bankers and shareholders with the needs of the broader economy.9 More intensive and effective supervision will reinforce internal governance and risk management.10 But the point is not to pile up capital and other regulatory capital requirements so high that banks are never heard from again as either a source of risk or credit to the real economy. No supervisory system can catch everything. The main responsibility for identifying and managing risk rests with each firm’s management, whose risk managers, compliance staff and internal audit personnel will always greatly outnumber the resources available to supervisors. And since regulation alone cannot optimise risk and return, the FSB is taking steps to enhance the role of the market in achieving the right balance. By ending too-big-to-fail and thereby subjecting firms to the ultimate sanction of the market, discipline in the system will increase. In Mexico, the G-20 also endorsed the FSB’s new road map to end the mechanistic reliance on credit ratings. Doing so will promote diverse private sector judgment, reducing cliff effects and building resilience. For a more complete discussion, see W. Byres, Secretary General of the Basel Committee on Banking Supervision, “Regulatory Reforms – Incentives Matter (Can We Make Bankers More Like Pilots?),” a speech to the Bank of Portugal conference on Global Risk Management: Governance and Control, Lisbon, 24 October 2012. See Financial Stability Forum, “FSF Principles for Sound Compensation Practices,” released on 2 April 2009, and FSB, “Principles for Sound Compensation Practices: Implementation Standards,” released on 25 September 2009. See FSB progress report, “Increasing the Intensity and Effectiveness of SIFI Supervision,” released on 1 November 2012. BIS central bankers’ speeches Moreover, improving risk disclosure, risk governance and risk management will further build a more resilient financial system. That is why I welcome the recently published report of the Enhanced Disclosure Task Force. This private sector effort, encouraged by the FSB, offers recommendations to provide investors with better disclosure about bank business models, key risks and risk-measurement practices. This should contribute, over time, to improved market confidence in financial institutions and financial market functioning, complementing regulatory developments by the public sector. I strongly encourage banks to implement these recommendations. As the Basel capital rules are implemented, as market infrastructure changes, and as banks – and, crucially, their investors – develop a better appreciation of their prospects for risk and return, banks are beginning to change their business models. Already, a couple of banks have fallen off the list of G-SIBs because they have simplified, downsized and de-risked their business models. Other institutions are de-emphasizing high-profile but risky capital markets businesses that benefited employees more than shareholders and society. As the reform process progresses, we can expect further adjustments that should ultimately lead to a more resilient, diversified sector with a more sustainable risk-return profile. Conclusion Last month in Tokyo, the International Monetary Fund rightly asked whether the financial system is safer today than on the eve of the crisis.11 The answer is yes. Despite the challenging economic environment, banks have substantially increased capital and liquidity. They are more actively managing risks. Countries are diligently implementing measures so that they can resolve failing institutions. The infrastructure of derivatives markets is being transformed to reduce systemic risks. The size of the shadow banking sector has fallen by 20 percentage points of GDP, back to levels last seen in 2004–05. However, while progress has been made, the global financial system is still not as safe as it needs to be. While much has been accomplished, much more needs to be done. The ambitious reform agenda I have described today will make a huge difference when fully implemented. All G-20 nations need to raise their game. That is why the FSB is increasingly focused on timely and consistent implementation of agreed reforms. We will identify those who drag their feet or bend the rules and hold them to account. The case for reform remains as clear today as it did when the G-20 began the process in 2008. Measures to strengthen financial stability support economic growth and create jobs rather than hold them back, even in the short term. Credit growth has resumed in those countries where financial institutions have decisively strengthened their balance sheets, refocused their core business activities, and improved their funding sources – in other words, returned to a more sustainable business model. As I have outlined today, more steps are required. But I can assure you, based on our recent conversations in Mexico, that the G-20 and the FSB remain resolute in their intention to create a more resilient, efficient global financial system. International Monetary Fund, Global Financial Stability Report: Restoring Confidence and Progressing on Reforms, October 2012. See Chapter 3: “The Reform Agenda: An Interim Report on Progress Toward a Safer Financial System.” BIS central bankers’ speeches
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the New York Association for Business Economics, New York, 27 November 2012.
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John Murray: The Great Frustration – hesitant steps toward global growth and rebalancing Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the New York Association for Business Economics, New York, 27 November 2012. * * * Introduction The collapse of Lehman Brothers on 15 September 2008 triggered a precipitous worldwide economic collapse. What had previously been viewed as a passing bout of “financial turbulence” was suddenly transformed into a full-blown panic. The U.S. economy, which was at the epicentre of the crisis, suffered its most severe downturn since the Great Depression. It could have been much worse. 1 Prompt and aggressive countermeasures by fiscal and monetary policy authorities eventually helped to stabilize the situation, and output began to recover toward the end of 2009 (Chart 1). However, a full four years after the collapse, real economic activity in the United States is scarcely above its pre-recession peak, and more than 4.5 million (net) jobs that were lost during the crisis have yet to be recovered. U.S. GDP is roughly 10 per cent below the level it would have reached had it continued to increase at the same trend rate of growth it experienced prior to the crisis (equivalent to more than $1 trillion). 2 Europe’s GDP has yet to return to its pre-recession peak, and is not expected to do so until 2015 at the earliest. The emerging-market economies (EMEs), including the BRIC countries (Brazil, Russia, India and China), which were growing at extraordinary rates prior to the crisis, did much better, but were still affected. Decoupling proved to be illusory. Several international institutions and respected researchers warned that recoveries following a financial crisis, especially one involving banks and real estate, were typically protracted and painful, but few expected the process to be this slow and this painful. The Great Moderation of the 1990s and early 2000s was followed by the Great Recession of 2008–09 and now, what one central bank governor has termed the “Great Frustration.” 3 I am not here to depress you, however. My speech today actually contains a message of hope. I will examine why the major advanced economies are where they are, and I will then describe what the future might hold. My message of hope does not come with any guarantees, however. It only points to the possibility of a more positive outcome. In order to reach it, a significant degree of enlightened self-interest will be required. I will begin with a quick review of the current situation, and compare it with where many of us thought, or hoped, we would be today. I will also show you where we might have been if timely and aggressive corrective action had not been taken. “Be thankful for what you have” might be the appropriate epitaph for the Great Recession – it could have been worse. This is followed by a discussion of the economic game plan that was laid out by the G-20 leaders at a meeting convened by President Obama in late 2009. This G-20 Framework for Strong, Sustainable and Balanced Growth was designed to deliver what the name suggests. 4 U.S. GDP fell by roughly 4 per cent from peak-to trough, while real economic activity in Europe and Japan fell by 6 and 8 per cent, respectively. This assumes, of course, that the previous trend rate of growth was sustainable. Remark by Glenn Stevens, Governor of the Reserve Bank of Australia, at a recent private meeting. For details of the G-20 Framework for Strong, Sustainable, and Balanced Growth. BIS central bankers’ speeches The third part of my presentation assesses what has transpired since 2009 – identifying those policy commitments that were fulfilled and those that were not, highlighting, in particular, the major failings. The fourth and final part of my presentation reviews where we need to go from here. That is the uplifting part of what I will say today. It’s not good, but it could have been worse The U.S. economy, as I noted a moment ago, has passed the peak that it reached just prior to the crisis, but it is well below where it would have been were it not for the collapse. Unemployment remains near 8 per cent, compared with an earlier (and perhaps unsustainable) trough of 4.4 per cent just before the crisis, and is well above consensus estimates of the structural or natural rate of unemployment. Excess capacity is judged to be in the range of 3 to 4 per cent of potential output. Chart 2 shows the state of the U.S. economy over the past five years (the solid red line), and where the Bank of Canada projects it will be going over the next two years (the dashed red line). The upper and lower bounds of the grey area represent the fastest and slowest recoveries of the U.S. economy following all of the previous post-Second World War recessions. As you can see, the red path is well below the lower bound. The experience in Europe has been even more disappointing relative to previous postwar recoveries (Chart 3). The outcomes for both the United States and Europe, however, have been much better than what was witnessed during the Great Depression (Chart 4). Make no mistake: This is where the major advanced economies were heading in late 2008. Indeed, output was falling at a far faster rate during this period than in late 1929. Only coordinated and exceptional policy measures prevented another Great Depression. G-20 Framework for Strong, Sustainable, and Balanced Growth By late 2009, output had started to rise at a reasonably robust rate in many, if not all, economies, and authorities were hopeful that the global economy was on the road to recovery. What little fiscal space the major advanced economies had been able to draw on in the midst of the crisis had been largely exhausted, however, and many central banks had lowered their target interest rates as far as they could go. As a result, a variety of unconventional monetary policy measures were deployed, involving large-scale asset purchases and exceptional forward guidance regarding the expected future path of short-term interest rates. Although these extraordinary measures helped to stabilize economic activity, and reverse the sharp declines, a longer-term strategy was clearly needed to restore global growth and put it on a more sustainable footing. What came forward from the G-20 was a four-point policy plan, the Framework for Strong, Sustainable and Balanced Growth. Each point was necessary on its own, but was also needed to ensure the success of the other three. The first point involved significant fiscal consolidation by countries that had run large, unsustainable budget deficits prior to the crisis and had seen them escalate even further during the recession, on the back of falling revenues and rising expenditures. Of course, banks and households in many of the same countries were also paying for past excesses, hastily deleveraging and working to repair broken balance sheets. The second point of the Framework called for sweeping financial system reforms. These were designed to rebuild financial institutions and markets in a way that would minimize the chances of future crises and make the system better able to withstand any that might occur. The third point focused on ambitious structural reforms to liberalize labour and product markets and improve governance and institutional arrangements, thereby raising long-term efficiency and potential output. BIS central bankers’ speeches The fourth and final point involved a rebalancing of global demand. Excess domestic demand in countries with current account deficits would be eliminated or reduced to manageable levels, and replaced by increased external demand from other, surplus, countries. Meanwhile, surplus countries were expected to boost their domestic demand and become less reliant on export-led growth strategies. Although these growth strategies had proven amazingly successful in many EMEs, they were often supported by persistent, large-scale, foreign exchange intervention and extensive capital controls intended to keep their currencies undervalued. With most deficit countries now played out and in the process of shrinking their demand, this was a strategy that couldn’t continue. Structural reforms in these EMEs, supported by more flexible, market-determined exchange rates, are required to sustain growth. The good, bad and ugly scenarios At the outset, observers were cautiously optimistic about the plan and, contrary to the warnings of Reinhart and Rogoff, believed that this time it might really be different. 5 Ideally, the appropriate combination of policies would shorten the recovery time and lead to a much better long-term equilibrium. The experiences of the five advanced countries that Reinhart and Rogoff had identified in their study, and that had been hit by financial crises earlier in the postwar period, would not be prologue to what advanced economies were about to achieve through concerted action. Regrettably, the trajectories of both the U.S. and European economies to date have been remarkably similar to these five countries (see the blue line on Charts 5 and 6). It would be a mistake, however, to assume that this experience represents some sort of immutable path toward which economies must necessarily gravitate following a crisis. Such an attitude is too defeatist and fatalistic. Good policy can – and does – make a difference. It is important to understand that the four points of the G-20 Framework that I described earlier are mutually reinforcing. The first three points, though they are essential for stable and welfare-improving outcomes in the future, were known to have deflationary effects in the short to medium term, depressing global demand. The fourth point, the rebalancing of global demand, was necessary to counter these sizable headwinds, supporting global growth until the positive effects from the other three kicked in. In an effort to highlight the costs of policy failure or, stated more positively, the potential gains from policy success, economists at the Bank of Canada used their global economy model in early 2011 to map out three possible scenarios. Although any econometric model needs to be treated with a great deal of caution, this one has proven to be very useful in the past, and the results were viewed as reasonable approximations of what one might expect under different states of the world. 6 The first scenario, called the “good” one, assumes that everyone does what is necessary to fulfill the G-20 commitments made in 2009 and at the three subsequent leaders’ summits. This scenario was not intended to be as good as it gets – a Goldilocks solution – but simply good enough to get the job done. The second, or “bad” scenario, assumes that most of what was promised is eventually accomplished, but with a three-year delay. The third scenario, called the “ugly” one, is a variant of the first two and assumes that only half the job is done, at least initially. Fiscal consolidation is undertaken, as is financial sector reform, but several C. Reinhart and K. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009). For more information on the model and the critical assumptions embedded in the scenarios, see C. de Resende, C. Godbout, R. Lalonde, É. Morin and N. Perevalov, “On the Adjustment of the Global Economy,” Bank of Canada Review (Spring) 2012. BIS central bankers’ speeches important structural reforms and a shift toward more flexible exchange rate regimes in some EMEs are omitted. The different growth trajectories implied by the three scenarios are evident in the results shown in Chart 7. The policy delay embedded in the bad scenario causes world output to fall roughly 8 per cent below the level of output that would have been realized under the good scenario (or US$6 trillion). Doing half the job, as in the ugly scenario, is even worse, at least for the first few years. This is mainly because the deflationary effects of fiscal consolidation are front-loaded. Where are we now? This is all very well, you might say, but how do these model results relate to the real world and what we see today? Where are we now, and how are we doing four years after the crisis started in earnest? The outcome in the real world has been decidedly mixed, despite additional rounds of quantitative easing and other unconventional monetary policy initiatives undertaken by major central banks. The deflationary forces in many countries appear to be winning. While global growth has not stalled completely, neither is it as strong or as widely distributed as many had hoped. Fiscal consolidation, with one or two notable exceptions, is being pursued by many of the countries that require it. However, there is a risk that market forces (or legislation, as in the case of the United States) may be pushing it too quickly in the short run. The International Monetary Fund and other policy institutions are now recommending that consolidation be pursued in a resolute but gradual manner, where possible. 7 In other words, don’t overdo it in the short run, since the fiscal multipliers are believed to be much larger than previously estimated. That said, there is a need for some countries, most notably Japan and the United States, to set out credible longer-term paths to restore their fiscal health. Their debt and deficits are on explosive tracks and will only be made worse by demographic forces. Financial system reform is where success has been the most evident, despite the ambitious nature of the agenda. 8 The design phase of the financial reform effort is nearing completion, but full, timely and consistent implementation of the reforms will be critical. Peer-review mechanisms have been established to help drive the process forward and maintain cross-jurisdictional consistency in implementation. 9 The cross-border challenges involved in implementing this reform effort are particularly daunting. The report card on structural reform is slightly better than some commentary might suggest, but progress has been extremely uneven. The structural initiatives announced by some countries lack ambition and are directed at easier, less politically sensitive, issues. Many other countries, however, whether of their own volition or under duress, are pursuing more far-reaching reforms. As one might imagine, many of these are deficit countries, subject to intense market pressures or operating under the surveillance of official support programs. Surplus countries, in contrast, have been less motivated and seem to have adopted a more relaxed approach. “Coping with High Debt and Sluggish Growth,” International Monetary Fund World Economic Outlook, (October 2012). “Progress of Financial Regulatory Reform,” letter from Financial Stability Board Chairman M. Carney to G-20 Finance Ministers and Central Bank Governors, 31 October 2012. T. Macklem, “Raising the House of Reform” (speech to Rotman Institute for International Business, Toronto, 7 February 2012). BIS central bankers’ speeches The final critical part of the Framework, the rebalancing of global demand, is where slippage has been the greatest, although at first glance things seem to have gone well. The real effective exchange rates of several important surplus countries have appreciated, and their current account balances have generally fallen (Chart 8). Export sales have declined and domestic demand now accounts for a larger share of their GDP growth. Appearances can be deceiving, however. While some legitimate progress has been made in the rebalancing of global growth, most of the “correction” that has occurred has been driven by demand compression in the deficit countries. The same is true for the rising share of domestic demand in many surplus countries. It is not a case of domestic demand growing significantly faster but, rather, declining export sales in the face of falling incomes and aggressive belt-tightening in deficit countries (Chart 9). In those instances where surplus countries have increased their contribution to global domestic demand, it has often been concentrated in fixed investment, which was already inordinately high and frequently misallocated. Investment as a share of GDP in China, for example, is roughly 50 per cent, while household consumption is roughly 35 per cent – extraordinarily low by any standard and declining over time (Chart 10). When growth returns to the deficit countries, the current account surpluses of these countries are likely to re-emerge. Without a conscious effort to rotate demand and support global growth, true re-equilibration will be a long and painful process. Another apparent sign of progress concerns the path of real exchange rates. In some surplus countries, exchange rates have shown signs of increased flexibility. However, these developments are quite limited compared with the movements observed in other, more truly flexible, regimes (Charts 11 and 12). They are also much less than fundamentals would suggest is appropriate. Many surplus countries continue to rely on capital controls and active foreign exchange intervention to enhance their competitive advantage. Taking all of this together, we appear to be trapped in the bad scenario. But if the situation continues, it could easily turn ugly. This is not to suggest that all of the difficulties that we have experienced are because of failed or partial policy implementation. There are two things worth noting in this regard. First, Reinhart and Rogoff are correct when they assert that recoveries after a major financial crisis, especially one that has gone global, are different than recoveries from “normal” recessions. Some allowance has to be made for this. Second, new shocks have hit the global economy since 2008. The earthquake in Japan and the crisis in Europe are the most obvious examples, although some would argue that the latter is simply an extension of the initial financial crisis. Even allowing for these factors, however, there is a sense that we could have done better. What needs to be done? Can we get back to where we want to be? In a word, yes. What is needed is very similar to what was first proposed and agreed in late 2009, but with some necessary modifications. The following list is not meant to be comprehensive but simply hits the highlights. First the United States must deal with its fiscal cliff. Action is required to bring the budget into line. But something with a smoother profile over the next two to three years, coupled with a credible long-term track would be preferable to the aggressive tack now in play. Second, Europe must set itself right. Certain things are required just to contain the crisis. These include activating the Stabilization Mechanism to help support sovereign debt re-financing and recapitalize banks, and the Outright Monetary Transactions program, which will help eliminate the risk of euro redenomination and improve the monetary policy transmission mechanism in the euro area. BIS central bankers’ speeches Of course, it will take several years to fully resolve the crisis in Europe. Key elements are further fiscal consolidation in many countries, repair of the broken banking systems, deep reform in labour and product markets, improved governance, and eventual completion of the banking, fiscal and political unions. Third, surplus countries that are delaying necessary global adjustment by frustrating necessary exchange-rate changes should move more expeditiously toward market-determined rates. In addition, they should undertake the structural changes necessary to boost domestic demand, with particular emphasis on consumption. This would allow more of their citizens to realize the full rewards of their labours and improve general economic welfare. Conclusion There is an old joke about a lost traveller who asks for directions and is told by a local, “I wouldn’t try to get there from here.” Unfortunately, we have no choice about our point of departure. It would be easier if we were starting from a better place, but we aren’t. Happily, the original road map established in 2009 remains broadly appropriate. 10 More may be required, since we have lost valuable time and capacity through delay, but the mission is not impossible. Let us first do what has been promised and then see what remains to be done. The good news is that many of the risks that we face are related to policy slippage and should therefore be amenable to policy correction. We have the means. Let us hope that lessons have been learned, and that the challenges will be met with renewed determination. Thank you. Canada, along with India, co-chairs the G-20 Working Group on the Framework, whose mission is to drive progress on the agenda. Its current focus 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. 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 and Chairman of the Financial Stability Board, to the CFA Society Toronto, Toronto, Ontario, 11 December 2012.
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Mark Carney: Guidance Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the CFA Society Toronto, Toronto, Ontario, 11 December 2012. * * * Introduction It is a pleasure to be here today to discuss guidance. Guidance is fundamentally about managing expectations, so let me manage yours up front. This speech is primarily about policy guidance; it will not itself provide new policy guidance. We all need guidance from time to time – we look to our parents, teachers, partners and peers for their help to make life, career or major financial decisions. Ultimately, though, these decisions are ours to make, and the consequences ours to bear. Taking responsibility is why you became Chartered Financial Analysts: to learn how to analyse information, to make difficult valuation and credit decisions, and to bear the risks and reap the rewards that result. You rely on accurate and full disclosure by the companies you analyse. Without it, you could not do your jobs; and, indeed, financial markets could not do theirs of bringing together savers and investors to allocate capital efficiently. With more CFA Charter holders per capita than any other major jurisdiction, Canada is favoured by such an emphasis on fundamental analysis at the core of our system. Beyond disclosure, what else can be usefully conveyed? Does the communication of companies’ expectations of performance serve a purpose? What about central bank expectations about future policy? In my remarks, I will discuss where such guidance can be effective and when it may be warranted. My main message is while transparency is critical to well-functioning capital markets and effective monetary policy, forward guidance of policy is best used sparingly in normal times. In extraordinary times, however, conditional guidance can be used to resolve time inconsistencies and achieve a better path for the economy. First, allow me to address the private sector use of guidance and its impact on the financial markets. Company disclosure An ongoing focus of regulators is ensuring that company disclosure is full, fair and timely. The crisis demonstrated the need for better disclosure by financial institutions. Insufficient and inconsistent disclosure by financial institutions contributed to uncertainty and eroded market confidence. This led to a withdrawal of market liquidity, depressed valuations and increased funding pressures. Regulators and market participants are addressing these shortcomings. An Enhanced Disclosure Task Force was formed last May at the initiative of the Financial Stability Board. This private sector Task Force is a unique undertaking that brings together senior officials from the banking sector, investors, analysts, rating agencies and audit firms, in consultation with international standard-setting bodies and national regulators. In its October report, the Task Force outlined principles and recommendations for improved risk disclosures that are better aligned with banks’ risk management and business strategies. Together with regulatory initiatives and capital increases, these measures will contribute to improved market confidence in financial institutions. BIS central bankers’ speeches Earnings guidance That companies should communicate material facts about their businesses, and do so to everyone at the same time, is no longer controversial. 1 There are, however, differing views as to whether companies should also provide their expectations of how their businesses will perform. Most research finds little evidence that earnings guidance systematically improves company valuations, increases shareholder returns or reduces market volatility. 2 Some even argue that forward earnings guidance can be harmful, focusing both financial market and company management attention on a short-term “numbers game” at the expense of long-term business fundamentals. 3 Accordingly, a number of companies have stopped providing earnings guidance, with research finding that these companies do see a subsequent increase in analyst forecast dispersion and a decrease in forecast accuracy – but no change in actual market volatility. 4 Is central bank communication different? First and foremost, central banks pursue transparency to be accountable in democratic societies. Moreover, research and experience demonstrate that clear and open communications also enhance the effectiveness of monetary policy. In particular, successful monetary policy requires transparency around two aspects of the policy approach – what we are trying to achieve and how we go about achieving it. With respect to the former, Canada has benefitted from a clear objective for monetary policy since the adoption of an explicit inflation target in 1991. As Canadians have come to understand the Bank’s policy objective and have gained confidence in its attainment over time, inflation expectations have become firmly anchored around the 2 per cent target. This confidence allows households and firms to make longer-term plans with greater confidence, aligning their savings, investment and spending decisions with a common inflation-control objective. These actions collectively serve to make the inflation target self-reinforcing. They also give the Bank greater latitude to respond aggressively to economic shocks without fear of dislodging longer-term inflation expectations. In short, the common understanding of our monetary policy objective makes its attainment easier. Of course, it would be quite remarkable if simply communicating the monetary policy objective were sufficient to ensure its achievement. The conduct of policy obviously matters as well. The Bank of Canada implements policy through changes in the target overnight interest rate, which has a limited direct impact on saving, investment and spending decisions. Far more important is the impact the Bank’s actions have on the broader spectrum of market interest rates, domestic asset prices and the exchange rate. What matters to these asset prices, however, is not so much the current setting of the policy interest rate but, rather, its expected path over time. Thus monetary policy affects the Regulation Fair Disclosure was adopted by the U.S. Securities and Exchange Commission in 2000 to address the problem of selective disclosure of information by publicly traded companies and other issuers. Regulation FD provides that when an issuer discloses material non-public information to certain individuals or entities, the issuer must make full public disclosure of that information. J.L. Rogers, D.J. Skinner and A. Van Buskirk, “Earnings Guidance and Market Uncertainty,” Journal of Accounting and Economics 48, no. 1 (2009): 90–109. P. Hsieh, T. Koller and S.R. Rajan, “The Misguided Practice of Earnings Guidance,” Perspectives on Corporate Finance and Strategy, The McKinsey Quarterly, No. 19 (Spring 2006). S. Chen, D. Matsumoto and S. Rajgopal, “Is Silence Golden? An Empirical Analysis of Firms that Stop Giving Quarterly Earnings Guidance,” Journal of Accounting and Economics 51 (2011): 134–50. BIS central bankers’ speeches economy primarily through policy-rate expectations. 5 The more those expectations are aligned with the policy path necessary to achieve the policy objective, the higher the probability the policy objective will be achieved. 6 The Bank of Canada has become significantly more transparent. We now explain our decisions eight times a year and provide rich supplemental detail in our quarterly Monetary Policy Report. 7 These communications are designed both to report the Bank’s views on the forces at work on the Canadian economy and to help households, firms and financial market participants understand how the Bank will respond to those forces over time. The goal here is, in effect, to allow markets and the public to “think along with us,” not only promoting the appropriate formation of policy expectations given current information, but also allowing those expectations to evolve efficiently as new information is received. We would have an easy time communicating our “reaction function” if we followed a simple mechanical rule. Life would indeed be easier if we could be so rigid. But achieving our target requires that we take a flexible policy approach, one informed by considered analysis and judgment. That is one reason why transparency – and occasionally guidance – matters. Guidance in normal times to help achieve the monetary policy goal In a perfect world, guidance would be unnecessary. The inherent uncertainty in economic outcomes and thus in the policy path would be widely understood. With full information and efficient markets, monetary policy expectations would effectively take care of themselves – knowing a central bank’s inflation objective and its reaction function would be sufficient for markets and the public to form and evolve their expectations, without the need for any direct guidance from the central bank. In the real world, monetary policy guidance can be useful in providing additional information. But this is not assured. How to get guidance right remains a subject of considerable debate. One approach is to provide advance signals to markets, using stock phrases or code words. Not surprisingly, this sort of signalling helps market participants predict policy decisions in the near term. 8 But it is not clear that fulfilling promises helps market participants understand why those decisions are taken. 9 Without this understanding, market participants may be even less able to form efficient expectations over time, thus increasing their reliance on explicit guidance from the central bank. Ultimately, the risk is that markets turn into an echo chamber, to the benefit of no one. Some other central banks directly disclose their policy interest rate forecast. “Putting it all out there” is, on its face, an appealing approach. It avoids the challenge of trying to perfectly J. Boivin, “How People Think and How It Matters,” a speech delivered to the Canadian Association for Business Economics, Kingston, Ontario, 23 August 2011. Note the contrast here to company earnings guidance, where expectations are essentially irrelevant to how the business actually performs, except indirectly through their effect on valuations and, thus, company funding conditions. J. Murray “Monetary Policy Decision-Making at the Bank of Canada,” a speech delivered to the Mortgage Brokers Association of B.C., Vancouver, British Columbia, 7 May 2012. See C. Rosa and G. Verga, “The Impact of Central Bank Announcements on Asset Prices in Real Time,” International Journal of Central Banking 4 no. 2 (June 2008): 175–217. C. Fay, T. Gravelle, “Has the Inclusion of Forward-Looking Statements in Monetary Policy Communications Made the Bank of Canada More Transparent?” Bank of Canada Discussion Paper 2010–15, November, 2010. BIS central bankers’ speeches calibrate verbal guidance. It also makes it easier to illustrate how monetary policy interacts with the economy. 10 In practice, however, it does not appear that markets take systematic account of the guidance offered by a published path beyond the very near term. Overall research has not generally found that publishing a path leads to better outcomes. 11 At the Bank of Canada, we take a different approach. We seek to provide the appropriate degree of transparency regarding how we intend to achieve our policy objective by regularly reporting on the forces we see at work on the economy and helping markets and the public understand how policy responds. The Bank occasionally provides guidance in normal times to give some sense of the imminence and degree of prospective policy action. We seek to place that guidance in the context of the most important economic and financial factors that will determine whether it is prophetic. This guidance is never a promise, however. Actual policy will always respond to the economic and financial outlook as it evolves. Market expectations of policy should do the same, reflecting differences in perspectives amid a common understanding of our objective. Let me offer some specific examples where the provision of additional guidance in normal times on the path of interest rates might be helpful. Headwinds and the neutral policy rate First, through the spring and summer of 2011, it became clear that some Canadian market participants were making the short-hand assumption that the policy interest rate needed to be at neutral when inflation was on target and the output gap was closed. 12 It was not fully appreciated that, in an environment of material headwinds, the last two conditions would only be satisfied if the policy rate remained at a more stimulative level to offset the impact of weaker foreign demand on the domestic economy. To clarify our approach and guide market participants, we inserted a Box in our July 2011 Monetary Policy Report (Charts 1 and 2). This helped reduce unrealistic views of the pace of future tightening. Communicating the links between price stability and financial stability A second example concerns the links between price stability and financial stability. Our flexible inflation-targeting framework requires that we re-evaluate – and communicate – the optimal path for returning inflation to target, taking due consideration of the consequences for volatility in output and financial markets. The variation in that optimal path has resulted in an inflation-targeting horizon as short as 2 quarters and as long as 11 quarters since the Bank began publishing its projections for inflation in 1998. The global crisis was a stark reminder that economic stability and financial stability are inextricably linked, and that pursuing the first without due regard for the second risks Publishing the policy rate forecast path corresponding to the central bank’s forecasts of growth and inflation helps to communicate both the central bank’s prevailing views on the economy and its policy reaction function, which in turn should help policy expectations evolve efficiently as new information arrives. 11. See, for example, M. Andersson and B. Hofmann, “Gauging the Effectiveness of Quantitative Forward Guidance Evidence from Three Inflation Targeters,” European Central Bank, Working Paper No. 1098, October 2009; C. E. Walsh, “Optimal Economic Transparency,” International Journal of Central Banking 3 no. 1 (March 2007): 5–36; and G.-A. Detmers and D. Nautz, “The Information Content of Central Bank Interest Rate Projections: Evidence from New Zealand,” Reserve Bank of New Zealand Discussion Paper No. 2012/03. level of the neutral rate itself is, of course, subject to some debate. For example, see D. Laidler, “Natural Hazards: Some Pitfalls on the Path to a Neutral Interest Rate,” Backgrounder No.140, C.D. Howe Institute, July 2011. BIS central bankers’ speeches achieving neither. While the primary tools to deal with financial stability are micro- and macroprudential regulation and supervision, it may be appropriate in some circumstances for monetary policy to contribute to financial stability directly by complementing macroprudential policy. 13 More specifically, because the consequences of financial excesses may be felt over a longer horizon than other economic disturbances, the potential may exist for tension between price and financial stability considerations over the typical monetary policy horizon. In current circumstances, the Bank may want to set interest rates higher than would otherwise be warranted to bring inflation back to target within the typical six- to eight-quarter time frame. But that flexibility does not exist in a vacuum, and should never be used by stealth. The most recent Financial System Review elaborates on risks related to household imbalances in Canada. Their evolution may be a factor affecting the timing and degree of any withdrawal of monetary stimulus. If the Bank were to lean against such imbalances, we would clearly say we are doing so, and indicate how much longer we expect it would take for inflation to return to the 2 per cent target. Our current guidance is that “some modest withdrawal of monetary policy stimulus will likely be required, consistent with achieving the 2 per cent inflation target. The timing and degree of any such withdrawal will be weighed carefully against global and domestic developments, including the evolution of imbalances in the household sector.” Our current guidance indicates that some policy action may be necessary, encouraging a degree of prudence in household borrowing. The share of new fixed rate mortgages has almost doubled to 90 per cent this year, reflecting the combination of attractively priced fixed-rate mortgages and the tightening bias of the Bank of Canada. Guidance as an unconventional policy tool While the Bank believes it appropriate to be sparing in forward policy guidance under ordinary circumstances, the calculus changes under extraordinary ones. When conventional monetary policy has been exhausted at the zero lower bound (ZLB) on nominal interest rates, the additional stimulus that is likely to be called for is impossible to achieve using the conventional interest rate tool. Extraordinary forward guidance is one unconventional policy tool, along with quantitative easing and credit easing. 14 The Bank of Canada used extraordinary forward guidance in April 2009, when the policy interest rate was at its lowest possible level and additional stimulus was needed. At the time, we committed to holding the policy rate at that level through the second quarter of 2010, conditional on the outlook for inflation. In effect, we substituted duration and greater certainty regarding the interest rate outlook for the negative interest rate setting that would have been warranted but could not be achieved. The Bank’s conditional commitment succeeded in changing market expectations of the future path of interest rates, providing the desired stimulus and thereby underpinning a rebound in growth and inflation in Canada (Chart 3). 15 When the inflation outlook – the explicit condition – changed, the path of interest rates changed accordingly. Bank of Canada, Renewal of the Inflation-Control Target, November 2011. Bank of Canada, “Framework for Conducting Monetary Policy at Low Interest Rates,” MPR, April 2009. See Z. He, “Evaluating the Effect of the Bank of Canada’s Conditional Commitment Policy,” Discussion Paper No. 2010–11, Bank of Canada, 2010; and M. Woodford “Methods of Policy Accommodation at the Interest-Rate Lower Bound,” paper presented at the Jackson Hole Symposium, “The Changing Policy Landscape,” 31 August – 1 September 2012. BIS central bankers’ speeches Our conditional commitment worked because it was exceptional, explicit and anchored in a highly credible inflation-targeting framework. It also worked because we “put our money where our mouths were” by extending the almost $30 billion exceptional liquidity programs we had in place for the duration of the conditional commitment. And it worked because it reached beyond central bank watchers to make a clear, simple statement directly to Canadians. Obviously the optimal policy path will differ for central banks, depending on their circumstances and mandates. For example, the Federal Reserve indicated at its September meeting that its policy rate could be expected to remain at exceptionally low levels until mid-2015, and provided additional certainty with respect to its reaction function by linking future unconventional monetary policy to substantial improvements in the outlook for the U.S. labour market. Further, it indicated that it will leave highly accommodative policy in place “for a considerable time after the economic recovery strengthens.” The Fed also expanded its large-scale asset purchases, dubbed “QE3,” consistent with this enhanced forward guidance. 16 Guidance and time inconsistency Doing more may require overcoming the familiar monetary policy challenge of time inconsistency – but not as it has been conventionally understood. 17 Today, to achieve a better path for the economy over time, a central bank may need to commit credibly to maintaining highly accommodative policy even after the economy and, potentially, inflation picks up. Market participants may doubt the willingness of an inflation-targeting central bank to respect this commitment if inflation goes temporarily above target. These doubts reduce the effective stimulus of the commitment and delay the recovery. To “tie its hands,” a central bank could publicly announce precise numerical thresholds for inflation and unemployment that must be met before reducing stimulus. 18 This could reinforce the central bank’s commitment to stimulative policy in the future and thus enhance the stimulative impact of its policies in the present, helping the economy escape from the liquidity trap. Further enhancing guidance may require a change in framework From our perspective, thresholds exhaust the guidance options available to a central bank operating under flexible inflation targeting. If yet further stimulus were required, the policy framework itself would likely have to be changed. 19 For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP U.S. Federal Reserve, Federal Open Market Committee Press Release, 13 September 2012. In the days before independent central banks, governments could not credibly commit to maintaining low and stable inflation, since they subsequently had the incentive to violate that commitment by engineering a growth-boosting inflation surprise. This time inconsistency led to the unfavourable stagflation equilibrium of the 1970s, and ultimately resulted in the widespread operational independence of central banks. See F. Kydland and E. Prescott, “Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy 85 (3) (1977): 473–92. See, for instance, C. L. Evans, “Perspectives on Current Economic Issues,” a speech delivered to the Bank of Ann Arbor Breakfast, Ann Arbor, Michigan, 18 September 2012. In most jurisdictions, including Canada, a change in the policy framework would require the approval of the political authority. In some others, it would require a change in the constitution. BIS central bankers’ speeches targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP (Chart 4). Bank of Canada research shows that, under normal circumstances, the gains from better exploiting the expectations channel through a history-dependent framework are likely to be modest, and may be further diluted if key conditions are not met. Most notably, people must generally understand what the central bank is doing – an admittedly high bar. 20 However, when policy rates are stuck at the zero lower bound, there could be a more favourable case for NGDP targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand. 21 Of course, the benefits of such a regime change would have to be weighed carefully against the effectiveness of other unconventional monetary policy measures under the proven, flexible inflation-targeting framework. Conclusion Companies can talk about their future performance, but cannot guarantee its delivery. Central banks can talk about the future path of policy, and we can, at least on the surface, deliver. However, in ordinary times, achieving our objective will mean delivering a path of policy that adjusts as economic circumstances evolve. Therefore, that path cannot be predicted with certainty in advance. In the Bank’s view, this limits the effectiveness of policy guidance to relatively special circumstances. In extraordinary times, policy guidance may be more appropriate, and, as the Bank has demonstrated with its conditional commitment, it can be highly effective. But, in more extreme circumstances, even such a conditional commitment may prove insufficient. In order to provide even greater stimulus when at the ZLB, central banks can further “restrain” their future policy path through pre-commitment or history-dependence. In all cases, central banks must be mindful of the impact on financial stability of what amounts to a “low for long” interest rate environment. This puts a premium on co-ordination among the relevant authorities to provide active macroprudential management. Our goal, as always, is to ensure that households, firms and investors can make their decisions in a stable macro environment. That will ensure that the fundamental analysis that CFAs perform every day plays a central role in capital allocation, business investment and ultimately jobs and growth. In particular, for the benefits of a history-dependent monetary policy framework such as NGDP targeting to be realised, people must be forward-looking, fully conversant with the implications of the regime and trust policy-makers to live up to their commitment. As Bank research has shown, if these conditions do not fully hold, these approaches could in fact prove destabilising to the economy and damaging to the central bank’s credibility. 21. Depending on the depth and duration of the ZLB episode, our calculations suggest that the adoption of a (temporary) price-level target, if well understood and credible, could eliminate more than half of the losses associated with the impossibility of providing additional monetary stimulus through a lower policy rate. See R. Amano and M. Shukayev, “Monetary Policy and the Zero Bound on Nominal Interest Rates,” Bank of Canada Review, Summer 2010 and C. l. Evans, “Monetary Policy in a Low-Inflation Environment: Developing a State-Contingent Price-Level Target,” remarks delivered before the Federal Reserve Bank of Boston's 55th Economic Conference, Boston MA, October 16, 2010. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Text of the W Edmund Clark Distinguished Lecture by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, at Queen's University, Kingston, Ontario, 10 January 2013.
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Tiff Macklem: Regearing our economic growth Text of the W Edmund Clark Distinguished Lecture by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, at Queen’s University, Kingston, Ontario, 10 January 2013. * * * Introduction It is a pleasure to be here at Queen’s. I discovered my passion for economics and its potential to inform public policy as a Queen’s student. I also developed a passion for a smart and attractive Queen’s Commerce student when I was here and we have been married now for more than 25 years. Our oldest son is currently a fourth-year Queen’s student – soon to be a graduate, I trust. And before all of us, my father went to Queen’s. So Queen’s has long played a big role in our family and I always like coming back. It is a particular honour to be here to deliver the W. Edmund Clark Distinguished Lecture. Ed Clark had an illustrious career with Canada’s federal public service before becoming a leader in the financial services industry. His success in both the public and private sectors, and particularly his contributions to building a stronger Canadian economy, is an inspiration to us all. So it is fitting that I will talk today about building on our economic strengths. As you know well, how you meet academic challenges depends a great deal on your preparation, determination and confidence. The same can be said of economic challenges. In my remarks today, I will review how these very qualities helped Canada outpace other major advanced economies through the recent global recession and recovery. I will also suggest that to maintain our leading position we need to build on our strengths, with determination and confidence, and rotate our growth so it is less reliant on credit-financed household spending and more geared to exports, investment and innovation. I will do this in two parts. I will begin with an 8-minute version – the short story, if you will. Then I will use the luxury of time afforded by this lecture to develop the short story in more detail and provide supporting facts and analysis along the way. The short story When you read the international economic and financial news, it is easy to feel queasy. The U.S. economy is experiencing its weakest recovery since the Great Depression and must now confront its fiscal realities. The euro area has fallen back into recession and must refound itself. The Japanese economy is floundering. By comparison, Canada has done well. We had the shortest recession and the strongest recovery among major advanced economies. Indeed, Canada is unique among this group to have regained its pre-recession level of both real GDP and employment (Charts 1 and 2). Canada is by itself in an expansion. Why have we done so well? It would be a conceit to think it is because we’re smarter, better educated, more inventive or harder working. The truth is more humbling. We had our crises earlier. In the 1970s, we lost our monetary anchor, and suffered the harmful consequences of high and variable inflation. In the mid–1980s, two Canadian banks failed and two more were saved only by merging with larger institutions. BIS central bankers’ speeches In the mid–1990s, contagion from the Mexican peso crisis caused foreign investors to wake up to Canada’s precarious fiscal situation, and we suffered our own sovereign debt crisis. Where we can take credit is that we learned from our mistakes. In the aftermath of each of these crises, we put in place sound policy frameworks. In 1991, Canada was the second country in the world to adopt an inflation target. The subsequent change in the behaviour of inflation was unequivocal. Since the adoption of the 2 per cent target, inflation has averaged very close to 2 per cent, and its variability, as measured by its standard deviation, has been cut by two-thirds (Chart 3). Following the bank failures of the 1980s, the government created a new prudential agency, the Office of the Superintendent of Financial Institutions (OSFI), with a clear mandate and the authority to take necessary corrective measures expeditiously. Financial regulatory standards were raised above international minimums, and supervision and oversight were strengthened. The fiscal transformation that followed our sovereign debt crisis was no less dramatic. After allowing government debt relative to GDP to rise almost without interruption from 1975 to 1995, successive governments ran 10 years of surpluses, cutting the government debt-to-GDP ratio from almost 70 per cent in 1995 to 22 per cent in 2008 (Chart 4). As a result, Canada’s net debt relative to GDP went from being the second-highest ratio among the G–7 countries in 1995 – second only to Italy – to the lowest today (Chart 5). Just as important, we have stuck with the discipline of these foundational policy frameworks while continuing to strengthen them, even as our crises have faded into history. These policy frameworks have served Canada well into the new millennium, underpinning almost two decades of solid and stable growth. But their full value was revealed through the recent global financial crisis. In Canada, no banks failed or had to be rescued, and our financial system continued to provide credit to households and businesses. So when the Bank of Canada, guided by its inflation target, lowered the policy interest rate to near zero and took the unconventional step of making a conditional commitment to hold the rate there for more than a year, the stimulative effects of monetary policy worked powerfully. 1 This monetary response was buttressed by a large fiscal stimulus package, including infrastructure spending, tax cuts and measures to enhance employment insurance, skills development and training. The combination of a financial sector that continued to work and extraordinary monetary and fiscal stimulus resulted in the smallest decline and by far the most rapid recovery in final domestic demand among major advanced economies (Chart 6). Thorough preparation combined with determined action and confident execution worked. With the recession behind us, the extraordinary fiscal stimulus has now been unwound. The Bank of Canada has moved off its exceptional policy, dropping its conditional commitment and raising the policy rate to 1 per cent. But with foreign headwinds in the form of a weak global recovery and elevated uncertainty, and a persistently strong Canadian dollar, the policy rate has remained at 1 per cent even as global financial conditions have improved and domestic lending rates have eased to near historic lows. This has provided ongoing support to household spending. As successful as it has been, this growth model is now reaching its limits. Today, the balance sheets of households are stretched. After 11 consecutive years with household outlays exceeding disposable income, household debt burdens have increased The Bank of Canada, together with the federal government, also provided exceptional liquidity to the financial system so that our sound banks could replace the short-term liquidity and wholesale funding that had dried up in the immediate aftermath of the failure of Lehman Brothers. BIS central bankers’ speeches substantially. Household debt as a percentage of disposable income has risen by almost 60 percentage points to 165 per cent today, 2 and Canadians are now more indebted than the Americans or the British (Chart 7). 3 Housing activity in Canada is at a near record share of GDP, and there are indications of overbuilding and overvaluation in some segments of the housing market. Reflecting the strength in spending relative to income, Canada’s current account has been in deficit for the past four years. These trends are not sustainable. The good news is that there are now signs a gradual correction of these imbalances may be under way. It is too early to tell whether it will continue, and there are risks on both sides. The correction could turn out to be short lived and the unsustainable trends could continue for a time. Or it could accelerate, risking too much adjustment too quickly. A gradual correction is desirable to reduce vulnerability and avoid a larger, more abrupt and disruptive correction in the future. But as desirable as a gradual correction is, something needs to take the place of increasingly leveraged household spending or economic growth in Canada will slow. The component of demand that has underperformed the most is exports (Chart 8). Indeed, exports are the only component of GDP that remain below their pre-recession peak. They have also underperformed when compared with most other advanced economies (Chart 9). To pick up the slack in exports will require investment, which has been the next weakest component of GDP. What to do? First, learn from the mistakes of others to ensure we are prepared for the risks ahead. Second, confront our weaknesses with clarity and determination. And third, have the confidence to build on our strengths. We are fortunate to have many: • a well-educated and increasingly efficient labour force; • privileged global access to capital; • abundant commodities; • a resilient financial system; and • sound fiscal and monetary policy. If we build on these strengths, there is no reason why we can’t regear our growth and retain our pole position among advanced countries. That’s the short version. I will now use the rest of this lecture to make this somewhat abstract prescription more concrete. As measured by Statistics Canada, see Chart 10. In Chart 7, for the purposes of international comparability, the data for Canada include both households and non-profit institutions serving households and the definition of disposable income is adjusted. BIS central bankers’ speeches Two challenges Stretched consumers Allow me to review the financial situation of consumers in a bit more depth. Household indebtedness is elevated and a range of indicators suggest that some segments of the housing market exhibit stretched valuations and overbuilding. 4 In the last 10 years, the pace of household debt accumulation has been unusually rapid. Household debt relative to disposable income increased about three times faster in the last 10 years than in the previous decade (Chart 10). The bulk of this rise in debt – 66 per cent, or $636 billion – has been in the form of mortgage debt, putting Canadians in an uncomfortable neighbourhood – between Spain and the United States – in the ranking of household mortgage debt across countries (Chart 11). Rising mortgage debt has fuelled housing activity, including resales, renovation and new home building. Housing activity has been elevated relative to historical norms for close to a decade now (Chart 12). After a sharp but brief decline when consumers froze in the darkest days of the financial crisis, housing activity rebounded quickly, rising to a near record level in 2012. The total number of housing units under construction is now well above its average relative to population (Chart 13). This is entirely accounted for by multiple-unit dwellings (which include condominium units). While this may to a degree reflect fundamental factors such as a shortage of land for single-family house development in some large metropolitan areas, there is also abundant anecdotal evidence that building has been spurred by investor demand, and is therefore more susceptible to changes in buyer sentiment. The strength in housing activity has also been reflected in rising house prices. Over the past decade, the price of the average home has risen from 3.5 times disposable income to more than 5 times (Chart 14), and the house price-to-rent ratio has increased from 1.3 to 2.3 (Chart 15). Both of these measures are now well above their historical averages. Restoring sustainable levels of borrowing and housing activity is a shared responsibility. First, households need to assess their ability to pay year after year, factoring in the reality that borrowing rates will eventually return to more normal levels. Many households are prudently responding by locking into fixed mortgage rates. The share of new fixed-rate mortgages increased from 50 per cent in 2011 to almost 90 per cent last year – a reflection of both attractively priced fixed rates and the Bank of Canada’s tightening bias. Second, banks and other lenders need to carefully consider risks when they extend loans to households. Third, the federal government has on four occasions between 2008 and 2012 taken prudent and timely measures to support the long-term stability of the housing market by tightening the minimum standards for government-backed insured mortgages. These measures have been complemented by OSFI’s new tougher underwriting standards for home-equity loans, enhanced supervisory scrutiny, and requirement that banks meet the more demanding Basel III capital standards as of January 2013, well ahead of the internationally-agreed maximum phase-in deadline of 2019. The cumulative effect of these measures, together with increased consumer awareness, is having an impact. In the past six months, the growth of household credit has continued to moderate, with total household credit growth slowing to slightly below 4 per cent in recent months (Chart 16). If this is sustained, the ratio of household debt to disposable income can be expected to stabilize later this year. For a more detailed discussion of the Bank’s current view of household finances and the housing market, see the Bank of Canada Financial System Review, (December 2012):19–32. BIS central bankers’ speeches Housing activity has also moderated recently. Sales of existing houses have softened, falling below their 10-year average in the third quarter. More recently, housing starts have also fallen from very high levels, declining from 225,000 units through much of 2012 to about 200,000 units in November and December. Even with this decline, housing construction remains above demographic demand, which is estimated to be about 185,000 units. Further slowing is expected to bring a convergence of housing starts and demographic demand this year. The growth in house prices has also slowed, although prices are still close to 18 per cent higher than the previous peak in August 2008 (Chart 17). These are encouraging signs of a stabilization of household imbalances and a more sustainable housing market. But after a decade of buildup, it is too early to be sure. Lacklustre exports Even though desirable, eliminating the household sector’s net financial deficit would leave a noticeable gap in the economy. The reduction of about $50 billion in annual household spending could be compensated by an additional 4 percentage points of annual export growth. Today, relative to the average recovery path for exports, we are losing $123 billion annually (Chart 18). In other words, in order to replace $50 billion in credit-financed household spending, exports need to close just two-fifths of the gap between the current recovery in exports and the average recovery. This should be doable. The underperformance of our exports is due in part to weakness in foreign demand. With the United States – our major trading partner – experiencing its worst recession and weakest recovery since the Great Depression, our exports fell sharply in 2008 and have recovered only slowly. But a longer view reveals that the global recession only exacerbated an already existing trend. In the last decade, Canada’s share of the world export market has slipped from about 4.5 per cent to about 2.5 per cent and our share of the export market for manufactured goods has been cut in half. Even more revealing, our export performance has been the second worst in the G–20 (Chart 19). Why have we done so badly? There are two reinforcing factors – structure and competitiveness. Two-thirds of this underperformance reflects who we trade with. 5 Almost 85 per cent of our exports go to slow growing advanced economies – 74 per cent to the United States alone – and only 9 per cent to fast growing emerging-market economies (EMEs) (Chart 20). Compared with our peers, Canada’s exposure to emerging markets is low when measured as a share of exports (Chart 21). The other third reflects declining competitiveness. This is manifest in our most important trading relationship, where we have lost considerable market share. From 2000 to 2011, China increased its share of U.S. imports from 8 to 18 per cent, surpassing Canada as the largest exporter to the United States (Chart 22). Over the same period, Canada’s share of U.S. imports fell from almost 20 per cent to less than 15 per cent. Moreover, while the large increase in China’s share is affecting other countries, a number of countries, notably Mexico and Germany, have fared much better than Canada. M. Carney, “Exporting in a Post-Crisis World,” (speech delivered to the Greater Kitchener Waterloo Chamber of Commerce, Waterloo, Ontario, 2 April 2012). Also see D. de Munnik, J. Jacob, and W. Sze, “The Evolution of Canada’s Global Export Market Share,” Working Paper No. 2012–31, Bank of Canada, October 2012. BIS central bankers’ speeches A comparison of the evolution of unit labour costs in Canada and the United States is telling. Between 2000 and 2011, the labour cost of producing a unit of output in Canada compared with the United States, adjusted for the exchange rate, increased 75 per cent (Chart 23). The majority of this loss of competitiveness reflects the appreciation of the Canadian dollar, but weak productivity growth in Canada relative to the United States played a significant role. Business sector labour productivity in Canada has grown at an average annual rate of just 0.8 per cent since the start of 2000, compared with 2.3 per cent in the United States. This accounts for about one-third of our lost competitiveness. What should Canadian businesses do? First, don’t count on a weaker Canadian dollar. Hoping for a weaker Canadian dollar is not a business plan. A sustainable export strategy cannot rely on expectations of a more favourable exchange rate, since Canada is likely to remain an attractive investment destination. Second, businesses should intensify their efforts to develop new markets for their products in fast-growing EMEs. This is being facilitated by a federal trade strategy that is increasingly EME focused. The Canadian government is currently negotiating a new trade agreement with India, has struck terms for a new investment agreement with China (the Canada-China Foreign Investment Promotion and Protection Agreement) and is participating in the multilateral negotiations of the Trans-Pacific Partnership. These are important initiatives – not just for our trade with EMEs, which now account for one-half of all global import growth – but also because they are essential to secure our positions in global supply chains. Third, improve productivity. To do that, we need to build on our strengths. Building on our strengths While our current growth model is reaching its limits, Canada has far from exhausted its opportunities. Quite the reverse – our strengths are many. Regearing requires building on them with determination, and harnessing their complementarity with confidence. I will start with our factors of production (labour, capital and commodities), before moving to critical enablers (our financial system and policy frameworks). A well-educated and flexible labour force The most important factor of production and our biggest strength is our labour force. Canadian workers are well educated, and our labour market is increasingly flexible. High-school completion in Canada is near universal, and Canadian students perform well relative to their peers, based on results of international assessments. Among the members of the Organisation for Economic Co-operation and Development (OECD), we have the highest level of tertiary education (including universities, colleges and polytechnics). Canada ranks well in the sciences, technology, engineering and maths, fields where the proportion of tertiary graduates exceeds the OECD average. We have strong research capacity centred on our universities, as measured by per capita academic of publications, which are well above the OECD average. And our spending on research and development (R&D) by institutions of higher education in proportion to GDP is the fifth highest in the OECD. 6 Over the past several decades, the efficiency of our labour market in matching workers and jobs has also improved dramatically. The Beveridge curve measures how well labour markets match workers looking for jobs with job vacancies (Chart 24). The closer the Beveridge curve is to its origin (zero vacancies and unemployment), the more efficient the labour market. As shown, the curve in the 1980s (blue line) has a higher level of Education at a Glance 2012, OECD Indicators. BIS central bankers’ speeches unemployment for a given level of vacancies than the curve in the 1990s and early 2000s (red line). 7 Part of that improvement in efficiency is due to the increasing mobility of Canadian workers. Interprovincial migration has long been an important adjustment mechanism for the Canadian economy. Recent Bank research suggests that long travel distances across Canada may not be as great a barrier to labour mobility as they once were. Over the past decade and a half, people have moved from regions with excess labour to those with the tightest labour markets, leading to the convergence of unemployment, participation and employment rates. By 2011, the gap, or disparity in employment rates across the 10 provinces, was at its lowest level and was not very different from the dispersion of employment rates across the United States (Chart 25). 8 In a geographically large, knowledge-based economy, these are important advantages. To regear, we need to build on them. While we are leading the world in tertiary educational attainment, we lag in the attainment of more advanced degrees and business degrees. Among OECD countries, we have the highest attainment of college degrees. For university degrees, we are only slightly above average, and for master’s and PhD degrees, we are in the bottom third. 9 In the field of business education, our proportion of graduates is slightly below the OECD average and 25 per cent below the United States. These trends in educational attainment are significant for at least two reasons. First, they show up in our work force. Compared with U.S. firms, Canadian firms lag in the employment of workers with advanced degrees and in the educational attainment of their managers. Canadian firms hire fewer employees with PhDs and other postgraduate degrees, especially in the sciences. Only one-third of managers in Canada have a university degree, compared with almost half of American managers. 10 Second, a significant body of research suggests that education improves the quality of management, and the quality of management influences investment in new technologies, in the introduction of new processes, and in the development of new markets. Highly educated individuals are much more likely to be owners of high-growth innovative firms. This all points to a need for more Canadian students to invest further in their education and for Canadian firms to put more emphasis on skills. There is also scope to further improve the matching of workers and jobs. There is some evidence of a mismatch between the supply of graduates in certain fields and the needs of employers. In particular, Canada has a disproportionately large share of university graduates in the bottom-earning quartile relative to other OECD countries. In addition, Canada’s employment rate for university graduates is below the OECD average. This underscores the importance of the dialogue between industry, labour and educational institutions to ensure that workers have the skills employers are seeking. It also points to the need to continue to eliminate differences in occupational licensing and other barriers to inter-provincial migration. Data on vacancies end in 2003. D. Amirault, D. de Munnik and S. Miller, “What Drags and Drives Mobility: Explaining Canada’s Aggregate Migration Patterns,” Working Paper No. 2012–28, Bank of Canada, 2012. OECD Economic Surveys, Canada June 2012. Institute for Competitiveness and Prosperity, “Management Matters,” Working Paper No. 12, March 2009; N. Bloom, “Management and Productivity in Canada: What Does the Evidence Say?” Industry Canada, Working Paper No. 2011–05. BIS central bankers’ speeches Privileged global access to capital Access to capital has rarely, if ever, been better in Canada, both on an absolute scale and relative to our competitors. Corporate bond yields in Canada are at record lows (Chart 26). Our surveys of banks and businesses suggest that business-lending conditions have continued to ease almost without interruption since late 2009 (Chart 27). Our economic advantages have made Canada an attractive investment destination and a rare safe haven in a risky world. This status is reflected in the behaviour of Canadian 10-year yields, which tend to decline at the same time as risky assets such as global equity prices. The correlation suggests that money flows into Canadian bonds in response to increases in perceived risk. Indeed, by this measure, Canada is viewed as among the safest of havens (Chart 28). This privileged global access to capital is a critical advantage. We need to use it wisely to invest in productive capital and research and development (R&D) rather than in houses. There is a large empirical literature that finds two of the best predictors of productivity growth are investment in machinery and equipment (M&E), particularly information and communication technology (ICT), and investment in R&D. Canada is lagging in both. Between 1987 and 2010, Canadian investment per worker in M&E and ICT averaged 74 per cent and 57 per cent, respectively, of that invested in the United States. By 2010, on average, Canadian workers had only about half as much M&E and ICT capital stock to work with as their U.S. counterparts. While public support for R&D in Canada is strong, business investment in R&D is below the OECD average and half the rate in the United States. Investment in Canada in recent years has been solid, but not spectacular. Despite record-low interest rates, historically low corporate leverage and a strong Canadian dollar, the recovery in investment remains below the average cycle (Chart 29). We need to invest more in M&E, and we need to get more out of these investments with greater spending on organizational capital and process improvement. To regear, we must do better than solid. Abundant commodities Abundant commodities have long played a critical role in our economic development but dramatic changes underway in the structure of the global economy have made commodities an even greater advantage. While commodity prices have fallen 19 per cent since their peak in April of last year, they remain about 20 per cent above their longer-term averages in real terms (Chart 30). In fact, real prices for energy and metals have been well above their long-term averages for more than eight years and real food prices are now at their highest level in 36 years. While commodity prices will continue to be volatile, this trend strength can be expected to persist. Underpinning this commodity super cycle is a sustained increase in demand from rapidly growing emerging markets, particularly China and India. Together, they account for most of the increase in global demand for commodities in the last five years. For example, increases in Chinese demand have played an important role in the rise of oil prices seen since 2002 (Chart 31). With convergence to Western levels of consumption still a long way off, the demand for commodities can be expected to remain robust and prices elevated for some time. In Canada, the impact of rising commodity prices has been reinforced by strong growth in the supply of some commodities. Oil is now our most important commodity by value, with its share of total Canadian commodity production rising over the past 15 years from 18 per cent to 46 per cent (Chart 32). BIS central bankers’ speeches Our challenge is to develop our commodities intelligently and sustainably and to ensure that the whole country benefits. Infrastructure investments in pipelines and refineries to get Western heavy oil, which is trading $40 below the world price, to Central Canada and to foreign markets would bring more of the benefits of the commodity boom to more of the country. Increased interprovincial trade in goods and services provides another channel to capture more of the value added from energy, mining and agriculture for all of Canada. This is already happening. For most provinces, trade inside Canada has continued to grow from 2007 to 2011, offsetting all or some of the weakness in international trade over the same period (Chart 33). Resilient financial system The financial system is a critical enabler, channelling savings to productive investments and helping firms and households to manage risks. Our banks withstood the 2008 financial crisis and are considerably stronger today than they were then. They have substantially lengthened liquidity horizons. They have increased their common equity capital by 77 per cent, or $72 billion, since the end of 2007. And, as of 10 days ago, Canadian banks met the new Basel III capital requirements, well ahead of the maximum phase-in period that extends to 2019. Businesses can be confident that bank funding will remain available. Core funding markets are also being strengthened so that market-based finance is a resilient source of diversification and innovation in funding markets, not instability. Last February, the Canadian Derivatives Clearing Corporation launched a new central counterparty service for repo transactions. Canada is on track to meet the G–20 commitments regarding the clearing of over-the-counter derivatives. In this regard, in October, Canadian authorities announced that market participants will be able to clear standardized over-the-counter derivatives using any central counterparty recognized by Canadian authorities, including global central counterparties. Our priority is to be among the leaders in adopting new, stronger global standards and to encourage others to do the same to maintain an open and competitive global financial system. Sound fiscal and monetary policy Thanks to our sound fiscal policy, Canada is among a select and dwindling group of countries with a risk-free rate. This is underpinning our privileged access to global capital. Canada’s competitive position is improving as other countries must increase taxes to address fiscal imperatives. And while returning to budget balance in Canada will require a determined effort, it pales in comparison to the scale and duration of the adjustment needed in the United States. There are very real benefits to Canada’s record of sound fiscal management. Finally, monetary policy. What can it do? Canadians can remain confident that inflation will remain low, stable and predictable. After more than 20 years of low inflation, the consequences of high and variable inflation are fading in the collective memory of Canadians, making it easy to discount the value of this commitment. That would be a mistake. Low and stable inflation has allowed consumers and businesses to manage their finances with greater certainty about the future purchasing power of their savings and income. Interest rates have also been lower and less variable in both nominal and real terms across a range of maturities. By working to stabilize inflation, monetary policy has helped to encourage more BIS central bankers’ speeches stable economic growth, lower and less variable unemployment, and greater efficiency in financial markets. 11 Maintaining low and stable inflation is the primary focus of monetary policy, but it is not the singular focus. Consistent with our mandate to “promote the economic and financial welfare of Canadians,” our flexible inflation-targeting framework requires that we consider the consequences for volatility in output, employment and financial markets when determining the optimal path and horizon over which to return inflation to target. In practice, the variation in that optimal path has resulted in an inflation-target horizon as short as two quarters and as long as 11 quarters since the Bank began publishing its projections in 1998. 12 This flexibility is enhanced by the credibility of Canada’s monetary policy. Inflation expectations are well anchored at the 2 per cent target. But this flexibility is also an asset that must be used with care. Credibility is hard to earn and easy to lose. While the crisis of 2008 re-affirmed the value of our flexible inflation-targeting framework, it was also a powerful reminder that price and financial stability are inextricably linked, and pursuing the first without due regard to the second risks achieving neither. The primary tools to deal with financial stability are micro- and macroprudential regulation and supervision. However, it may be appropriate in some circumstances for monetary policy to complement macroprudential policy and contribute to financial stability directly. There can be tension between price and financial stability over the typical monetary policy time frame because the consequences of financial excesses may be felt over a longer horizon than other economic disturbances. In current circumstances, the Bank may want to set interest rates higher than would otherwise be warranted to bring inflation back to target within the typical six- to eight-quarter time frame. In particular, the Bank has indicated that the evolution of household imbalances may be a factor affecting the timing and degree of any withdrawal of monetary stimulus. If the Bank were to lean against such imbalances, we would clearly say we are doing so, and indicate how much longer we expect it would take for inflation to return to the 2 per cent target. For now, signs indicate that the pace of household-debt accumulation is moderating, but, as I have stressed already, it is too early to tell if this will be sustained. Conclusion It is time to wrap up. I will conclude with a brief comment on current economic developments. As I mentioned earlier, housing activity is beginning to decline broadly in line with our expectations. Canadian exports are expected to add to GDP growth, but continue to be restrained by weak foreign demand and ongoing competitiveness challenges. Economic activity in the third quarter of last year was weak owing in part to transitory disruptions in the energy sector. We continue to expect economic activity to pick up through 2013, but near-term momentum now appears to be slightly softer than previously anticipated. These and other developments will all be taken into consideration as we revise our economic projections, to be published on January 23 with the next interest rate decision. The strength and durability of the pick-up in growth through 2013 and beyond will depend critically on how successful we are in regearing our growth to exports, investment and innovation. We are well prepared. We have a myriad of strengths. If we build on these with T. Macklem, “A Measure of Work” (speech to the Winnipeg Chamber of Commerce, Winnipeg, 4 October 2012). Bank of Canada, “Renewal of the Inflation-Control Target: Background Information – November 2011.” BIS central bankers’ speeches determination and confidence, there is no reason why we cannot continue to outperform our peers to the benefit of all Canadians. 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 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 and Chairman of the Financial Stability Board, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 23 January 2013.
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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 and Chairman of the Financial Stability Board, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 23 January 2013. * * * 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. • While the global economic outlook is slightly weaker than the Bank had projected in October MPR, global tail risks have also diminished. • The economic expansion in the United States is continuing at a gradual pace, restrained by ongoing public and private deleveraging, global weakness and uncertainty related to fiscal negotiations. • Europe remains in recession, with a somewhat more protracted downturn now expected than in October. • Growth in China is improving, though economic activity has slowed further in some other major emerging economies. • Supported by central bank actions and by positive policy developments in Europe, global financial conditions are more stimulative. • Commodity prices have remained at historically elevated levels, though temporary disruptions and persistent transportation bottlenecks have led to a record discount on Canadian heavy crude. • In Canada, the slowdown in the second half of 2012 was more pronounced than the Bank had anticipated, owing to weaker business investment and exports. • Caution about high debt levels has begun to restrain household spending. • The Bank expects economic growth to pick up through 2013. • Business investment and exports are projected to rebound as foreign demand strengthens, uncertainty diminishes and the temporary factors that have weighed on resource sector activity are unwound. • Nonetheless, exports should remain below their pre-recession peak until the second half of 2014, owing to a lower track for foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. • Consumption is expected to grow moderately and residential investment to decline further from historically high levels. The Bank expects trend growth in household credit to moderate further, with the debt-to-income ratio stabilizing near current levels. • Relative to the October MPR, Canadian economic activity is expected to be more restrained. Following an estimated 1.9 per cent in 2012, the economy is expected to grow by 2.0 per cent in 2013 and 2.7 per cent in 2014. The Bank now expects the economy to reach full capacity in the second half of 2014, later than anticipated in October. • Core inflation has softened by more than the Bank had expected, with more muted price pressures across a wide range of goods and services, consistent with the unexpected increase in excess capacity. BIS central bankers’ speeches • Total CPI inflation has also been lower than anticipated, reflecting developments in core inflation and weaker-than-projected gasoline prices. • Total CPI inflation is expected to remain around 1 per cent in the near term. It is expected to rise gradually, along with core inflation, to the 2 per cent target in the second half of 2014 as the economy returns to full capacity and inflation expectations remain well-anchored. • Despite the reduction in global tail risks as a result of a series of actions by European and American authorities, the inflation outlook in Canada is still subject to significant risks. • The three main upside risks to inflation in Canada relate to the possibility of stronger-than-expected growth in the U.S. economy, higher Canadian exports and renewed momentum in Canadian residential investment. • The three main downside risks to inflation in Canada relate to the European crisis, more protracted weakness in business investment and exports in Canada, and the possibility that growth in Canadian household spending could be weaker. • Overall, the Bank judges that the risks to the inflation outlook in Canada are roughly balanced over the projection period. • Reflecting all of these factors, the Bank today maintained the target for the overnight rate at 1 per cent. • While some modest withdrawal of monetary policy stimulus will likely be required over time, consistent with achieving the 2 per cent inflation target, the more muted inflation outlook and the beginnings of a more constructive evolution of imbalances in the household sector suggest that the timing of any such withdrawal is less imminent than previously anticipated. With that, Tiff and I would be pleased to take your questions. BIS central bankers’ speeches
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Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Weatherhead Center for International Affairs, Harvard University, Cambridge, Massachusetts, 11 February 2013.
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Timothy Lane: Financial stability in one country? Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Weatherhead Center for International Affairs, Harvard University, Cambridge, Massachusetts, 11 February 2013. * * * Introduction During the years since the global financial crisis, financial reforms have been moving forward on two distinct levels. The G-20 leaders’ commitment to build a more stable and resilient global financial system is being advanced through an ambitious global reform agenda. At the same time, policy-makers in each country are implementing reforms intended to establish more stable and resilient systems in their respective jurisdictions. Financial stability in each country is, of course, an essential ingredient of global financial stability: policies to achieve financial stability in different jurisdictions are in most cases highly complementary, as a stable global financial system is made up of stable national financial systems. But tensions do sometimes arise between these two objectives. At the root of these tensions is the pervasiveness of cross-border spillovers – both from the risks affecting financial stability and from some of the reforms designed to mitigate those risks. In Canada – an open economy where the financial system is closely linked with those of the United States and other countries – we have a privileged vantage point on these issues. Our experience during the global financial crisis and its aftermath is a reminder that financial stability at the national level cannot be fully secured in the face of economic and financial shocks originating elsewhere. Financial instability speaks all languages and carries many passports. Furthermore, financial reforms have important cross-border implications that need to be addressed to ensure that these reforms have their intended benefits. Thus, financial stability is a shared responsibility that must be advanced through international cooperation. Reforms agreed to at the global level need to be implemented fully and consistently in each jurisdiction. In my remarks today, I am going to draw on Canada’s experience of the past few years to illustrate these points. First, I will review how Canada fared during the financial crisis. Second, I will discuss the risks to Canada’s financial stability that have emerged in the wake of the crisis. Third, I will focus on some important cross-border elements of the reform agenda. Canada and the crisis It’s now well known that Canada came through the financial crisis better than many other major advanced economies, with a relatively short and shallow recession and a relatively strong recovery. It is now over two years since Canada regained its pre-recession level of both real GDP and employment (Chart 1). An important reason Canada fared better than other countries was that our financial system was more robust. Canada’s banking system was rated “the soundest in the world” by The Banker magazine three years in a row, from 2008 to 2010. No Canadian financial institutions failed – or had to be rescued by taxpayers – during the crisis. Leading up to the crisis, our banks were less leveraged, less dependent on wholesale financing, and less exposed to the structured financial products that brought down some of their peers in other countries. This in turn reflected, at least in part, Canada’s tougher regulatory standards and stricter supervision and oversight. Canada’s established policy framework and strong fiscal position gave the authorities considerable room for manoeuvre when the crisis struck. These strengths, in turn, BIS central bankers’ speeches were the legacy of the harsh lessons Canada learned during the 1980s and 1990s from failures of two small banks and our own sovereign debt problem. Nonetheless, Canada’s financial stability came under stress during the crisis. Serious risks materialized, and had to be countered by timely and aggressive policy action. Liquidity conditions in Canada’s core funding markets – although not as extreme as in other jurisdictions – became very tight: in the climate of fear following the failure of Lehman Brothers, many Canadian institutions had difficulty obtaining funding (Chart 2). In response, the Bank of Canada provided substantial short-term liquidity support to the financial system: we made this support available to a broader group of institutions, for longer terms, and against a wider range of collateral than under normal conditions. During this period, the Canadian government also provided longer-term funding to Canadian banks to prevent a severe credit crunch in the private sector (Chart 3).1 As a result of these actions, Canada’s core funding markets stayed open, and credit kept flowing to the private sector (Chart 4). As the global crisis gave way to the Great Recession, Canada’s economy suffered the consequences – mainly through a collapse in exports to the United States, which was in a deep recession. Canada lost output amounting to more than 4 per cent of real GDP and job losses equivalent to almost 2 1/2 per cent of our labour force. But an aggressive policy response helped to prevent a worse outcome. The Bank of Canada eased policy substantially in order to achieve its 2 per cent inflation target: it lowered the overnight policy rate to its lowest possible level (1/4 per cent) and took the unconventional step of making a conditional commitment to hold it there for more than a year (Chart 5). Complementing this monetary policy response, the government introduced a broad-based fiscal stimulus package amounting to about 3 1/2 per cent of GDP. While the recession did put stress on the financial system – in particular, a tightening of credit conditions and an increase in loan losses – the short duration of Canada’s recession kept more serious threats to financial stability at bay. Global deleveraging and Canada’s unbalanced expansion The years since the crisis have brought a different set of challenges to financial stability in Canada. History teaches us that recoveries after a financial crisis are slower than those following normal recessions – a pattern that has been well documented, in particular, by Harvard professors Carmen Reinhart and Kenneth Rogoff.2 Typically, it takes output twice as long to return to its pre-recession level after a financial crisis as in a normal recovery, and potential output is permanently lower compared with its pre-crisis growth trajectory. This is because the legacy of a financial crisis is a lot of debt. Working off that debt – in other words, deleveraging – drags down the economy. The recession following the recent global financial crisis has run true to form. In a world awash in debt, repairing the balance sheets of banks, households and governments can take years. In the United States and many other advanced economies, households are no longer the engine of growth that they were before the crisis, since they have been curtailing their spending to rebuild the wealth lost in the housing crash. While much progress has been Government support was provided through the Insured Mortgage Purchase Program (IMPP), which allowed the commercial banks to sell insured residential mortgages to the federal government-owned Canada Mortgage and Housing Corporation. This program made available a potential Can$125 billion, although only about Can$70 billion was used. C. Reinhart and K. Rogoff, “This Time Is Different: Eight Centuries of Financial Folly” (Princeton, N.J.: Princeton University Press, 2009). BIS central bankers’ speeches made, household deleveraging has hobbled private sector growth. In many countries, financial institutions have also been restraining their lending because of the losses they incurred and the need to become less heavily leveraged. And a number of governments too have been restricting their spending and raising taxes, aiming to restore sustainable fiscal positions. This process of deleveraging in other advanced economies creates significant challenges for Canada’s financial stability. Specifically, the slow growth path resulting from deleveraging in our largest trading partner – the United States – creates a headwind to Canada’s economy. This headwind has, in particular, been holding back Canada’s exports, which are far from recovering from their plunge at the start of the recession. As a result, Canada has relied on domestic demand – mainly spending by households – to achieve even a modest rate of economic growth (Chart 6). Although it’s better to have unbalanced growth than no growth, this pattern does pose certain risks. Consumers have taken advantage of the stimulative financial conditions, including low borrowing costs and easy availability of financing, that were put in place to counterbalance the external headwinds. In doing so, they have pushed household debt to levels that pose a significant risk (Chart 7). The proportion of households with stretched financial positions that leave them vulnerable to an adverse shock has grown significantly in recent years. These conditions are also reflected in stretched valuations in some segments of Canada’s housing market. Also, more houses are being built than are needed given demographic trends (Chart 8). These developments have led to a significant buildup of vulnerabilities in Canada’s household sector. The risk is that any shock to economic conditions could be amplified through a deterioration of housing market conditions and a retrenchment of household spending. These conditions could then be transmitted to the broader financial system through a worsening of the credit quality of loans. This could prompt a tightening of credit conditions and, in turn, set off a mutually reinforcing deterioration in real activity and financial stability. While the Bank of Canada has characterized these household vulnerabilities as the most important domestic source of risk to Canada’s financial stability, the origins of this risk are only partly domestic: it is also an after-effect of the global crisis. The crisis gave rise to global deleveraging and weak growth that created headwinds to Canada’s economy. In the face of those headwinds, very stimulative monetary policy has been needed to achieve the inflation target. And that prolonged stimulative policy – “low for long” – creates significant risks to financial stability. I’ve highlighted the risks associated with the household sector, but low-for-long interest rates can lead to risks elsewhere in the financial system. Periods of low interest rates may, in some circumstances, trigger a “search for yield” driving excessive risk-taking – often through investment strategies whose risks are not well understood. Until recently, this tendency toward excessive risk-taking has been kept in check by the climate of fear in the post-crisis global financial system – and an acute awareness of some important tail risks. Market participants have been concerned about the euro area crisis, the fiscal cliff in the United States, and the possibility of a hard landing in China. In the past few months, extreme negative outcomes appear less likely, and market participants have regained confidence. While it is good news that the tail risks have diminished, it also means that it is now becoming even more important to monitor financial institutions’ risk-taking behaviour. The risks of household imbalances, as well as other risks associated with low for long, can be addressed in several ways. First, households, financial institutions and investors need to make prudent decisions. More normal times will return, and with them more normal interest rates and costs of borrowing. It is the responsibility of households to ensure that they can BIS central bankers’ speeches service tomorrow the debts they take on today. As for investors, they are responsible for managing the risks they face. Financial institutions also have a responsibility to make sure that their clients can service their debts and more broadly, that they understand the risks to which they are exposed. Among the policy measures that can be used to address emerging financial system vulnerabilities, targeted prudential measures are often the best. The Canadian government has tightened regulations pertaining to government-backed insured mortgages four times – most recently in 2012.3 These changes involve more stringent requirements to qualify for mortgages, shorter amortization periods and lower maximum loan-to-value ratios for mortgages. In addition, the prudential regulator has recently issued guidelines for the mortgage underwriting standards of lenders. If such targeted prudential measures turned out to be insufficient, monetary policy could also be used, within a flexible inflation-targeting framework, as a complementary instrument to address financial imbalances. So far, though, that has not been necessary in Canada. The growth of household credit has shown signs of moderating in recent months. The momentum in house price growth, sales of existing homes, and new construction has also moderated. Nonetheless, financial system risks associated with household imbalances remain elevated. And it is possible either that household spending could regain momentum or that a more sudden weakening could occur. Think globally, act locally So far, I have been using Canada’s experience during and after the global financial crisis to illustrate the cross-border dimension of the threats to financial stability. Now I would like to talk about the cross-border dimension of the reform agenda and how it intersects with national priorities and policy-making. Unprecedented in scope, the direction of reform is often agreed at the global level, but where the rubber hits the road is usually at the national – and in some cases even provincial or state-level. In this context, one salient feature of the financial reforms is that they will not only benefit the jurisdiction where they are implemented, but also other jurisdictions. If we look at the costs and benefits of the Basel III reforms to increase capital at financial institutions, we see that reforms impose costs on banks which may in part be passed on to their customers through wider spreads between deposit and lending rates – in turn generating some broader macroeconomic effects. At the same time, evidence suggests that higher capital standards reduce the frequency and severity of financial crises. Research at the Bank of Canada indicates that, on balance, the benefits will far outweigh the costs: Basel III, by improving the safety and robustness of the Canadian and international financial systems, should yield a net economic benefit to Canada equivalent to about 13 per cent of GDP in present-value terms. But here is the key point: three-quarters of the prospective benefits for Canada arise from the decrease in the probability of financial crises in other countries – and only one-quarter from the reduced probability of a financial crisis in Canada itself.4 Similar logic would apply to the United States and other countries, but the arithmetic is particularly compelling for a smaller open economy like Canada. These calculations go a long way in explaining why Canada is so committed to the global reform process – and to ensuring that reforms are fully implemented in all jurisdictions. Canada has already put in place Basel III capital standards. While there have been delays in See Bank of Canada, Financial System Review, Box 2, Table 2-A, “Mortgage Insurance Rules in Canada” (December 2012): 24. Bank of Canada, “Strengthening International Capital and Liquidity Standards: A Macroeconomic Impact Assessment for Canada” Bank of Canada (August 2010). BIS central bankers’ speeches some other jurisdictions, the largest financial institutions in the United States are already Basel III compliant, in terms of capital. We trust that other jurisdictions will continue to move forward to implement these agreed standards. To help ensure that they do – under the principle “trust but verify” – a robust peer-review mechanism has been established to track how jurisdictions are progressing in living up to their G-20 financial reform commitments. All financial reform is local Some of the reforms taking place at the national level mainly involve the implementation of what has been agreed at the international level. Clearly, in putting these international standards in place, individual countries need to align them with their own financial structures and circumstances. In some jurisdictions – the United States, the European Union and the United Kingdom – reform has also been proceeding somewhat independently of the global process. A prominent example in the United States is the Dodd-Frank Act which was passed into law in 2010 and is still in the process of being implemented through extensive rule making. Different approaches to achieving broadly similar objectives are being followed in the European Union, the United Kingdom and Japan. While the various national reform agendas have essentially the same objectives as the global agenda – a safe and efficient financial system – there can be tensions between them, including conflicts, inconsistencies and overlaps, which can affect financial institutions and their clients operating across national borders. Reforms of over-the-counter derivatives trades are a good example. The United States and Europe are taking a leadership position and pushing ahead with legislation in this area. Conflicts in national regulation may arise, in which the rules of one jurisdiction cannot be followed without contravening a requirement in another. For example, trade reporting rules proposed by the U.S. Commodity Futures Trading Commission may require data that could violate privacy and information laws in some other countries. Inconsistencies may occur when requirements apply to certain products or participants in one country, but not in others. Non-financial companies, for example, may or may not be exempt from central clearing obligations depending on the country. Even in the absence of such conflicts and inconsistencies, duplicate obligations across jurisdictions may increase compliance costs, undermining economic efficiency. National legislation can also have extra-territorial effects. An example is the Volcker Rule banning proprietary trading by deposit-taking institutions, which is being introduced in the United States as part of the Dodd-Frank legislation. Under the regulations initially proposed, any foreign financial institution with operations in the United States would be required to comply with the proprietary trading ban on its worldwide operations. Here, the intention is to prevent institutions from shifting activities offshore in a bid to avoid the ban on proprietary trading. Moreover, U.S. government bonds were exempted from the rule, while other sovereign bonds were not. Thus, for example, Canadian financial institutions’ trading in Canadian government bonds could be restricted under U.S. law. These proposed regulations have raised concerns that U.S. law could dictate the structure of major financial institutions in many other jurisdictions. Other jurisdictions – including Canada – have objected, both because they do not wish to have U.S. law applied to the primarily domestic operations of their institutions, and also because they do not agree that the Volcker Rule is the only – or the most effective way to prevent excessive risk-taking in financial institutions. An essential element of resolving potential tensions is mutual recognition: each jurisdiction should have a sufficiently strong regime that other jurisdictions can accept as broadly BIS central bankers’ speeches equivalent, eliminating the need to impose their own rules across borders.5 The foundation of mutual recognition is to have generally accepted global standards together with a robust peer-review mechanism to ensure that those standards are applied consistently across jurisdictions. Collaborative resolution Given the interconnectedness of financial institutions, collaboration is a key element of implementing reforms. One area where collaboration is particularly important is in the resolution of systemically important financial institutions – those deemed “too big to fail.” Designing a clear framework for resolution has been a priority of the global financial reform agenda. Owing to the size and complexity of cross-border linkages in banking and financial markets, when a major financial institution or market is impaired in one country, shocks can quickly spread to the financial systems of other countries. During the crisis, differences in rules – and in interests – across jurisdictions impeded the resolution of financial institutions such as Lehman Brothers. In this light, it is essential to have a clear basis for cross-border collaboration in the resolution process. For banks identified as globally systemically important (G?SIBs), crisis-management groups have largely been established to provide a forum for the ongoing exchange of information and the coordination of recovery and resolution measures. The G-SIBs are preparing “recovery and resolution plans” that would facilitate an orderly winding up of the institution if that becomes necessary. Achieving the most beneficial level of co-operation for cross-border resolution, however, is a challenge. While the establishment of the crisis-management groups is an essential element in the process, much remains to be done. Financial protectionism The issues I have raised, the cross-border dimensions of both financial instability and reform, could have another unintended result: that of a more fragmented global financial system. This tendency – as reflected, for example, in the decline in cross-border financing since the crisis – stems naturally from the greater perceived risks of cross-border financial activities, together with regulations that seek to protect domestic financial systems (Chart 9). A reduction in cross-border interconnectedness may help to reduce contagion, but an unintended consequence could be excessive concentration and interconnectedness within countries. More generally, barriers to the movement of capital may carry a significant cost, in the form of lost economic efficiency and growth. From a global perspective, these considerations need to be balanced carefully. If we look at the deleveraging of financial institutions, a necessary step as they repair balance sheets and meet new regulations, we see that how they deleverage can lead to fragmentation. For instance, in the European Union, national regulators have discouraged banks from deleveraging through restricting credit in their own respective jurisdictions. Partly for this reason, a number of banks, particularly in the euro area, have been withdrawing from international activity. In part, this has also meant increasing banks’ exposure to their own sovereigns – a major channel amplifying stress during the recent euro-area crisis. One example of mutual recognition is the jurisdictional reciprocity for internationally active banks in the countercyclical capital buffer framework. See Basel Committee on Banking Supervision, “Guidance for national authorities operating the countercyclical capital buffer” (December 2010): 5. BIS central bankers’ speeches A second source of fragmentation is the potential conflict between rules in different jurisdictions. To the extent that conflicting, duplicate and/or extra-territorial regulations make cross-border activity disproportionately costly, they may create incentives for financial institutions to concentrate their activities in their own jurisdictions. Fragmentation can also occur from explicit financial protectionism. Some emerging market economies, for example, have sought to insulate their own financial systems from turbulent global financial conditions through a range of measures designed to constrain cross-border capital flows, including capital controls which in some cases are accompanied by foreign exchange market intervention. The adoption of such measures by a number of countries could result in a greater concentration of risk in national economies and ultimately undermine global economic growth. Conclusion The global reform agenda, which is critical to financial stability across countries, will need, by its very nature, to be underpinned by global cooperation. New standards agreed upon at the international level must be implemented at the national level. As we move past the policy-development phase, processes are being put in place to monitor implementation, including cross-country peer reviews of specific standards by the Financial Stability Board. Domestic reform initiatives are equally important, but need to be harmonized in an integrated world. If conflicts and inconsistencies arise from the requirements of different jurisdictions, these initiatives may not succeed in establishing a safer global financial system. Financial stability is necessary for sustainable economic growth. But it’s a public good: its benefits are widely shared. Can it be achieved in one country alone? Not a chance. We’re all in this together. 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 and Chairman of the Financial Stability Board, presented to the House of Commons Standing Committee on Finance, Ottawa, Ontario, 12 February 2013.
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Mark Carney: Summary of Canada’s January 2013 Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, presented to the House of Commons Standing Committee on Finance, Ottawa, Ontario, 12 February 2013. * * * Good morning. Tiff and I are pleased to be here with you today to discuss the January Monetary Policy Report, which the Bank recently published. • While the global economic outlook is slightly weaker than the Bank had projected in October MPR, global tail risks have also diminished. • The economic expansion in the United States is continuing at a gradual pace, restrained by ongoing public and private deleveraging, global weakness and uncertainty related to fiscal negotiations. • Europe remains in recession, with a somewhat more protracted downturn now expected than in October. • Growth in China is improving, though economic activity has slowed further in some other major emerging economies. • Supported by central bank actions and by positive policy developments in Europe, global financial conditions are more stimulative. • Commodity prices have remained at historically elevated levels, though temporary disruptions and persistent transportation bottlenecks have led to a record discount on Canadian heavy crude. • In Canada, the slowdown in the second half of 2012 was more pronounced than the Bank had anticipated, owing to weaker business investment and exports. • Caution about high debt levels has begun to restrain household spending. • The Bank expects economic growth to pick up through 2013. • Business investment and exports are projected to rebound as foreign demand strengthens, uncertainty diminishes and the temporary factors that have weighed on resource sector activity are unwound. • Nonetheless, exports should remain below their pre-recession peak until the second half of 2014, owing to a lower track for foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. • Consumption is expected to grow moderately and residential investment to decline further from historically high levels. The Bank expects trend growth in household credit to moderate further, with the debt-to-income ratio stabilizing near current levels. • Relative to the October MPR, Canadian economic activity is expected to be more restrained. Following an estimated 1.9 per cent in 2012, the economy is expected to grow by 2.0 per cent in 2013 and 2.7 per cent in 2014. The Bank now expects the economy to reach full capacity in the second half of 2014, later than anticipated in October. • Core inflation has softened by more than the Bank had expected, with more muted price pressures across a wide range of goods and services, consistent with the unexpected increase in excess capacity. BIS central bankers’ speeches • Total CPI inflation has also been lower than anticipated, reflecting developments in core inflation and weaker-than-projected gasoline prices. • Total CPI inflation is expected to remain around 1 per cent in the near term. It is expected to rise gradually, along with core inflation, to the 2 per cent target in the second half of 2014 as the economy returns to full capacity and inflation expectations remain well-anchored. • Despite the reduction in global tail risks as a result of a series of actions by European and American authorities, the inflation outlook in Canada is still subject to significant risks. • The three main upside risks to inflation in Canada relate to the possibility of stronger-than-expected growth in the U.S. economy, higher Canadian exports and renewed momentum in Canadian residential investment. • The three main downside risks to inflation in Canada relate to the European crisis, more protracted weakness in business investment and exports in Canada, and the possibility that growth in Canadian household spending could be weaker. • Overall, the Bank judges that the risks to the inflation outlook in Canada are roughly balanced over the projection period. • Reflecting all of these factors, the Bank, on 23 January, maintained the target for the overnight rate at 1 per cent. • While some modest withdrawal of monetary policy stimulus will likely be required over time, consistent with achieving the 2 per cent inflation target, the more muted inflation outlook and the beginnings of a more constructive evolution of imbalances in the household sector suggest that the timing of any such withdrawal is less imminent than previously anticipated. 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 and Chairman of the Financial Stability Board, to the 7th Annual Thomas d'Aquino Lecture on Leadership, Lawrence National Centre for Policy and Management, Richard Ivey School of Business, Western University, London, Ontario, 25 February 2013.
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Mark Carney: Rebuilding trust in global banking Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the 7th Annual Thomas d’Aquino Lecture on Leadership, Lawrence National Centre for Policy and Management, Richard Ivey School of Business, Western University, London, Ontario, 25 February 2013. * * * Introduction Six years ago, the collapse of the global financial system triggered the worst global recession since the Great Depression. Losing savings, jobs, and houses has been devastating for many. Something else was lost – trust in major banking systems. This deepened the cost of the crisis and is restraining the pace of the recovery. The real economy relies on the financial system. And the financial system depends on trust. Indeed, trust is imbedded in the language of finance. The word credit is derived from the Latin, credere, which means “to have trust in.” Too few banks outside of Canada can claim credit today. Bonds of trust between banks and their depositors, clients, investors and regulators have been shaken by the mismanagement of banks and, on occasion, the malfeasance of their employees. Over the past year, the questions of competence have been supplanted by questions of conduct. Several major foreign banks and their employees have been charged with criminal activity, including the manipulation of financial benchmarks, such as LIBOR, money laundering, unlawful foreclosure and the unauthorized use of client funds. These abuses have raised fundamental doubts about the core values of financial institutions. In my remarks today, I will discuss the breakdown of trust and what is required to rebuild it. The G-20’s comprehensive financial reforms will go a long way but will not be sufficient. Virtue cannot be regulated. Even the strongest supervision cannot guarantee good conduct. Essential will be the re-discovery of core values, and ultimately this is a question of individual responsibility. More than mastering options pricing, company valuation or accounting, living the right values will be the most important challenge for the more than one-third of Ivey students who go into finance every year. Trust is strained at multiple levels Between banks and their shareholders: Most major banks outside Canada are now trading well below their book value, indicating shareholder concerns about a combination of the quality of bank assets and the value of their franchises (Chart 1). Between banks and their debt-holders: Bank credit ratings have been downgraded, and even the revised ratings reflect continued reliance on sovereign backstops (Chart 2). Between banks and their supervisors: For too many institutions, concerns over competence, conduct and, ultimately, culture have fed supervisory concerns and built the political case for structural measures, such as ring fencing, or prohibiting certain activities, such as proprietary trading. Between supervisors in advanced economies: Fearful that support from parent banks cannot be counted upon in times of global stress, some supervisors are moving to ensure that subsidiaries in their jurisdictions are resilient on a stand-alone basis. Measures to ring fence the capital and liquidity of local entities are being proposed. Left unchecked, these trends BIS central bankers’ speeches could substantially decrease the efficiency of the global financial system. In addition, a more balkanized system that concentrates risk within national borders would reduce systemic resilience globally. Between emerging and advanced economies: Given that the crisis originated in the advanced economies, the incentives for emerging and developing economies to ring fence their financial systems are particularly pronounced. This has been, at times, supplemented by more active management of capital inflows, further fragmenting the global system. Finally, and most fundamentally, there has been a significant loss of trust by the general public in the financial system. There is a growing suspicion of the benefits of financial deregulation and cross-border financial liberalisation, a suspicion that could ultimately undermine support for free trade and open markets more generally.1 The costs are potentially enormous A global system that is nationally fragmented will lead to less efficient intermediation of savings and a deep misallocation of capital. It could reverse the process of global economic integration that has supported growth and widespread poverty reduction over the last two decades. Within economies, the hesitancy of firms to invest reflects in part low confidence that their banks will be there to provide credit through the cycle. Reduced trust in the financial system has increased the cost and lowered the availability of capital for non-financial firms. The massive response of central banks has provided some offset but access to credit remains strained. Consider fractional reserve banking, which allows banks to transform savings into investments, driving growth and wealth creation. At its core, such banking relies on the trust of depositors, bonds of trust that are so vital they have been reinforced by the state through deposit insurance and supervisory oversight. In turn, the trust between financial counterparties multiplies base money created by the central bank many times, creating an aggregate credit supply that finances our modern economy. When trust in the system is lost, this process reverses. Depositors and investors become reluctant to provide funding to banks, banks to lend to other banks, and, in some of the most affected countries, both are sceptical of the ability of governments to backstop the system.2 Since the crisis, money multipliers have plummeted in the crisis economies. In the United States and European Union, the ratio of M2/M0 fell by 55 and 40 per cent, respectively, between 2006 and 2012. While some of the decline reflects the end of excess and the weakness of credit demand in a deleveraging economy, the magnitude of the decline indicates the extent to which trust has been shaken. In contrast, in Canada, where trust in the system has, if anything, increased, the ratio has risen by 22 per cent (Chart 3). Rebuilding trust: the Five Cs So what to do? A combination of institutional and individual initiatives – the “Five Cs” – is required. See also “The Financial Crisis Inquiry Report: The Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States,” Financial Crisis Inquiry Commission, January 2011. This skepticism is in part related to the fiscal and sovereign debt situations in some of the affected countries. BIS central bankers’ speeches The G-20’s comprehensive financial reforms will go a long way to rebuild trust. The good news is that there has been progress, even if it is not yet fully reflected in market valuations or public attitudes. Capital Many people remember the pivotal moment when Lehman Brothers collapsed, but that was only one example of a widespread failure of banking models across the advanced economies. That same year, major banks in the United States, the United Kingdom, Germany, France, Ireland, Switzerland, the Netherlands and Belgium either failed or were rescued by the state. Gallingly, on the eve of their collapse, every bank boasted of capital levels well in excess of the standards of the time. So it should be no surprise when building a more resilient system, the first priority was to strengthen the bank capital regime. Through higher minimums, surcharges for systemically important banks, countercyclical buffers and tougher definitions of capital, the largest banks will have to hold at least seven times as much capital as before the crisis. As a backstop to the risk-based capital framework, a simple, but effective leverage ratio has been imported from Canada. It protects the system from risks we might think are low but in fact are not. Since the end of 2007, major banks in the United States and Europe have increased their common equity capital by $575 billion and their common equity capital ratios by 25 per cent. Canadian banks are setting the pace. Since withstanding the financial crisis, they have become considerably stronger. Their common equity capital has increased by 77 per cent, or $72 billion, and they already meet the new Basel III capital requirements six full years ahead of schedule. Clarity Greater clarity, the second “C,” is critical to well-functioning capital markets. In the run-up to the crisis, financial institutions became increasingly opaque. Their balance sheets were stuffed with mark-to-model assets, massive undisclosed contingent exposures, and debt classified as regulatory capital. Annual reports ran over 400 pages in some cases, leaving investors exhausted but no better informed. In the past few years, there have been some improvements, including better accounting for off-balance-sheet securitisations, and enhanced disclosures of credit risk and the transfers of financial assets. Encouraged by the G-20, U.S. and international accounting standard-setters have made progress toward a single set of high-quality reporting standards, particularly in the areas of revenue recognition and asset valuation. But more is required. The two boards have not yet been able to agree on a common approach for asset impairment based on expected, rather than incurred, losses. The G-20 has now called on them to redouble their efforts. One of the most important initiatives to improve clarity is the work of a private sector group, the Enhanced Disclosure Task Force (EDTF), which was formed at the encouragement of the Financial Stability Board (FSB).3 It has made a series of recommendations to improve annual financial reporting by banks based on seven principles. Disclosures should be clear, “Enhancing the Risk Disclosures of Banks,” Report of the Enhanced Disclosure Task Force (29 October 2012). BIS central bankers’ speeches comprehensive, relevant, consistent, comparable, and timely. Finally, annual reports should explain how risk is actually managed. Once adopted, enhanced disclosure will contribute to effective market discipline, better access to funding, and, importantly, improved market confidence in banks. The Bank of Canada joins the Office of the Superintendent of Financial Institutions in encouraging major Canadian banks to implement the EDTF standards as soon as is possible. Better disclosure of a bank’s current financial condition can be usefully supplemented by regular assessments of the impact of stress on it. Stress tests can expose excessive mismatches in maturities and currencies, find evidence of undue forbearance in lending and reveal excess or correlated asset concentrations. In the current environment, the FSB has emphasised particularly the value of stressing against sharp movements in yield curves. Capitalism Perhaps the most fatal blow to public trust has been the perception of a heads-I-win-tailsyou-lose finance. Bankers made enormous sums in the run-up to the crisis and were often well compensated after it hit. In turn, taxpayers picked up the tab for their failures. Thus, at the heart of financial reform must be measures that restore capitalism to the capitalists. To that end, the FSB is enhancing the role of the market. The measures to improve clarity will enhance market discipline. The development of effective resolution tools will also help diminish the moral hazard associated with “too big to fail.” The FSB has identified those banks that are systemically important at the global level and developed a range of measures that, once implemented, will help to ensure that any financial institution can be resolved without severe disruption to the financial system and without exposing the taxpayer to the risk of loss. The knowledge that this could happen should enhance market discipline of private creditors who previously enjoyed a free ride at the expense of taxpayers. While solid progress has been made it is not yet mission accomplished. In the coming months, jurisdictions need to articulate comprehensive plans to resolve each systemic institution. These should include effective cross-border agreements for handling a failure and, a minimum amount of bail-inable liabilities and the publication of a presumptive path for resolution. To take stock, the FSB will report to the G-20 leaders at the St. Petersburg Summit on the extent to which “too big to fail” has been ended and, if not, what further steps are required. Connecting with clients Financial capitalism is not an end in itself, but a means to promote investment, innovation, growth and prosperity. Banking is fundamentally about intermediation – connecting borrowers and savers in the real economy. Yet, too many in finance saw it as the apex of economic activity. In the run-up to the crisis, banking became more about banks connecting with other banks. Clients were replaced by counterparties, and banking was increasingly transactional rather than relational. These attitudes developed over years as new markets and instruments were created. The initial motivation was to meet the credit and hedging needs of clients in support of their business activities. However, over time, many of these innovations morphed into ways to amplify bets on financial outcomes. BIS central bankers’ speeches An important example of a useful, but eventually misused, innovation is securitisation, which initially provided funding diversification for banks while spreading risk among investors with different load-bearing capacities. However, in the run-up to the crisis, highly complex chains developed, linking low-risk money market funds with high-risk subprime mortgages via off-balance-sheet structured investment vehicles (SIVs). Banks sold mortgages into the SIVs and many of the SIVs in turn wrote credit insurance contracts, often to the very banks that sponsored them, to “insure” the bank’s proprietary credit positions. These links with banks were simultaneously too weak and too strong. The shift of credit exposure from originating bank to the SIV eroded 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. Moreover, the insurance provided by the SIV was only as good as the quality of the mortgages bought by the bank. These dynamics were at the heart of the Canadian non-bank asset-backed commercial paper fiasco. Similarly, the rapid expansion of banks into over-the-counter derivatives was initially motivated by the desire to provide hedges to their clients as end-users. These transactions eventually morphed into a mountain of intra-financial system claims, largely divorced from end-users, with banks and other financial entities trading among themselves. The magnitude of these developments was remarkable. In the final years of the boom, the scale of shadow-banking activity exploded. The value of structured investment vehicles, for example, almost tripled in the three years to 2007. Credit default swaps grew sixfold over the same period. As intra-financial sector claims grew, banks became increasingly detached from their ultimate clients in the real economy. In most professions, people see the ‘real’ impact of their work: teachers witness the growth of their students, farmers that of their crops. When bankers become disconnected from their ultimate clients in the real economy, they have no direct view of the impact of their work. The LIBOR-setter sees only the numbers on the screen as a game to be won, ignoring the consequences of his or her actions on mortgageholders or corporate borrowers. Fortunately, there are some signs that global banks are returning to their roots. Complex securitisation chains have dissolved. Mechanistic reliance on credit ratings is declining. With higher capital requirements on trading activities (and the prospect of structural restrictions), traditional lending is looking more attractive. These shifts will promote diverse private sector judgments, reduce cliff effects and build resilience, and possibly over time, a measure of trust. But there arguably has not yet been a full recognition of the need for banks to return to what Ed Clark calls “old fashioned banking – activities that help grow their country and communities.”4 To do this, some banks may need to reconsider their values. Core values The fifth “C” – core values – is the responsibility of the financial sector and its leaders. Their behaviour during the crisis demonstrated that many were not being guided by sound core values. Many in the wake of the crisis looked first to how compensation affects behaviour. Indeed, an important lesson was that compensation schemes that delivered large bonuses for short- E. Clark, “Building a Better Banking System for America” (speech to Chief Executives’ Club of Boston, Boston College, Boston, MA, 26 April 2012). BIS central bankers’ speeches term returns encouraged individuals to take on too much long-term and tail risk. In short, the present was overvalued and the future heavily discounted. To better align incentives with long-term interests of the firm and, more broadly, society, the FSB developed Principles and Standards for Sound Compensation Practices. Core elements include deferred variable performance payments, paying bonuses in stock rather than cash, and introducing bonus clawbacks. Of course, no compensation package can fully align the incentives of a bank’s shareholders and its risk-takers. Even if such a package could be devised it would not internalise the impact of individual actions on systemic risks, including on trust in the banking system. More fundamentally, to think that compensation arrangements can ensure virtue is to miss the point entirely. Integrity cannot be legislated, and it certainly cannot be bought. It must come from within. Purely financial compensation ignores the non-pecuniary rewards to employment, such as the satisfaction received from helping a client or colleague succeed. When bankers become detached from end-users, their only reward is money, which is generally insufficient to guide socially useful behaviour.5 Few regulators and virtually no bankers saw these limitations. Beliefs in efficient, selfequilibrating markets fed a reliance on market incentives that entered the realm of faith.6 As Michael Sandel has observed, we moved from a market economy towards a market society.7 This reductionist view of the human condition is a poor foundation for ethical financial institutions needed to support long-term prosperity. To help rebuild that foundation, bankers, like all of us, need to avoid compartmentalisation or what the former Chair of HSBC, Stephen Green, calls “the besetting sin of human beings.”8 When we compartmentalise, we divide our life into different realms, each with its own set of rules. Home is distinct from work; ethics from law. In the extreme, as Ed Clark observed, “Bank leaders created cultures around a simple principle: if it’s legal and others are doing it, we should do it too if it makes money. It didn’t matter if it was the right thing to do for the customer, community or country.”9 To restore trust in banks and in the broader financial system, global financial institutions need to rediscover their values. This was the conclusion of research conducted here at Western.10 For companies, this responsibility begins with their boards and senior management. They need to define clearly the purpose of their organisations and promote a culture of ethical business throughout them. R. Rajan, “When Money Is the Measure of All Worth,” in Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton,N.J.: Princeton University Press, 2010). T. Padoa-Schioppa, “Markets and Government Before, During, and After the 2007-20XX Crisis,” (Per Jacobsson Lecture, 27 June 2010, Basel, Switzerland). Michael J. Sandel, What Money Can’t Buy: The Moral Limits of Markets (New York: Farrar, Straus and Giroux, 2012). S. Green, Good Value: Reflections on Money, Morality and an Uncertain World (London: Allen Lane 2009). E. Clark (remarks delivered at the Bank of Canada Annual Economic Conference, “Financial Intermediation and Vulnerabilities,” Ottawa, 2 October 2012). J. Gandz, M. Crossan, G. Seijts, and C. Stephenson, “Leadership on Trial: A Manifesto for Leadership Development,” Richard Ivey School of Business, 2010. BIS central bankers’ speeches But a top-down approach is insufficient. Employees need a sense of broader purpose, grounded in strong connections to their clients and their communities. To move to a world that once again values the future, bankers need to see themselves as custodians of their institutions, improving them before passing them along to their successors. Conclusion It has been said that, “trust arrives on foot, but leaves in a Ferrari.”11 After the Ferrari screeched out of the parking lot in 2008, what steps have been taken to rebuild trust? There has been progress. As the new Basel capital rules are implemented, and the reliance on ratings agencies diminishes, market infrastructure improves; and as banks – and, crucially, their investors – develop a better appreciation of their prospects for risk and return, business models are beginning to change. Already, a couple of banks have fallen off the list of globally systemic banks because they have simplified, downsized and de-risked their business models. Other institutions are deemphasizing high-profile but risky capital markets businesses that benefited employees more than shareholders and society. Global banks have made significant progress in reforming their compensation practices so that rewards more closely match risk profiles. In addition, boards of directors and risk committees are taking more responsibility to ensure that remuneration packages and employee behaviour are aligned with updated institutional cultures.12 Unfortunately, a spate of conduct scandals ranging from rigging LIBOR to money laundering has overshadowed these steady and material improvements. This underscores that it remains the collective responsibility of banks, regulators and other stakeholders to rebuild trust in banking. Banks need to participate actively in reform, not fight it. Until recently, too few bankers acknowledged their industry’s role in the fiasco. The time for remorse is far from over. At the same time, the public sector needs to be more vocal and appreciative when the industry makes major contributions. This has been the case with the EDTF and in work on bail-in debt, a key element of ending “too big to fail.” In addition, the best global organisations are now recognising the need to address their corporate ethics. All of these efforts should be publicly encouraged and reinforced. Ultimately, it will be down to individual bankers, including the Ivey grads who will go into finance. Which tradition will you uphold? Will your professional values be distinct from your personal ones? What will you leave those who come after you? R. Sermon, “Investing in Integrity” (speech to the Trust and Integrity in the Global Economy Conference, Caux, Switzerland, 19 July 2012). See a summary of a recent FSB workshop with the financial industry on compensation practices, and the most recent FSB peer review of compensation practices. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Association for Financial Professionals of Canada (Montreal Chapter), Montreal, 26 March 2013.
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Agathe Côté: Toward a stronger financial market infrastructure for Canada – taking stock Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Association for Financial Professionals of Canada (Montreal Chapter), Montreal, 26 March 2013. * * * Introduction It’s a pleasure to be here today. I am going to take advantage of this audience of financial professionals to talk about financial market infrastructure, a subject that affects every single person in one way or another – you, because of the nature of your work, more than others. Usually, when people talk about infrastructure, they think about roads and transportation systems. Montrealers, like everyone who lives in a big city, know only too well what happens when a city’s infrastructure system is weak or fails: delays, disruptions of all kinds, and various degrees of chaos. The nature of infrastructure is such that we only truly understand its importance when it fails us. The same goes for financial market infrastructure. Virtually all financial transactions are cleared, settled and recorded through financial market infrastructures (FMIs). FMIs allow consumers and firms to safely and efficiently purchase goods and services, make financial investments, and transfer funds. Given the critical role of FMIs, their risk management is of paramount importance; indeed, the subject of “systemic risk” was a hot topic in discussions about infrastructure long before the recent financial crisis. Over the past twenty years, there has been a steady stream of improvements, for example, developing payments systems and safely settling foreign exchange transactions across time zones. These improvements proved their worth during the crisis. Despite numerous institutional failures around the world and extreme levels of uncertainty and risk aversion, FMIs continued to perform their critical functions. The crisis also highlighted the importance of one type of FMI in particular – central counterparties (CCPs). A CCP acts as a buyer to every seller and a seller to every buyer for the financial transactions that it clears. An appropriately risk-controlled CCP improves the market’s resilience by reducing counterparty credit risk and, therefore, the potential for disruptions to be transmitted through the financial system. This helps essential markets to remain continuously open, even in times of severe stress. A CCP also provides enhanced netting efficiencies to its members, and helps to manage defaults in a controlled manner. For example, the Lehman Brothers default, one of the most memorable and dramatic of the recent crisis, would have been even worse if the London Clearing House, which is the CCP for a large portion of OTC interest rate derivatives, had not managed the default as well as it did. More generally, we saw that markets served by CCPs tended to be more resilient during the crisis than bilaterally settled markets. Given this track record, it is not surprising that market infrastructure, and CCPs in particular, have been key elements of the G-20’s efforts to strengthen financial stability. The Bank of Canada has a very strong interest in FMIs. Under the Payment Clearing and Settlement Act, the Bank is responsible for the regulatory oversight of FMIs with a view to controlling systemic risk in Canada. BIS central bankers’ speeches But the Bank is just one part of the equation. Canada’s regulatory community and the industry are moving forward together to strengthen Canadian financial market infrastructure, and thus increase the resilience of the financial system. In the rest of my remarks, I will highlight some of the principal initiatives under way. Considerable progress has been made, but there is still work to be done. Greater participation in the Canadian CCP for fixed-income repos is essential I will start with an initiative that is close to home. Here in Montréal, the Canadian Derivatives Clearing Corporation (CDCC) launched a central counterparty service for the Canadian fixedincome repo market called the Canadian Derivatives Clearing Service (or CDCS) in February 2012. This CCP has been under the oversight of the Bank of Canada since 30 April 2012.1 Repos represent a major source of wholesale funding for financial institutions and are critically important to the functioning and liquidity of other important related markets, such as the market for government bonds. CDCS was developed to facilitate a continuously open repo market, and to help prevent a repeat of the severe liquidity crunch that occurred in this market during the recent financial crisis.2 In the short time since it began operations, CDCS has expanded its product offerings, added participants and seen a steady increase in the average daily value cleared through the system. This is all to the good, but not enough. At present, just 10 to 15 per cent of repo transactions are cleared through CDCS – not nearly enough to ensure that the markets remain open in times of stress. While most of Canada’s major banks and securities broker-dealers are currently CDCS participants, the majority of Canadian repo trades involve at least one non-CDCS participant on one side of the transaction.3 Since CDCS cannot clear a trade unless both counterparties are participants, it will not be able to materially increase the proportion of the repo market that it serves without capturing a broader set of participants. Clearly, the challenge is getting more participants on board, but several issues must be addressed before some institutions can participate given the current CDCS model. For instance, smaller dealers may not be willing or able to meet daily operational demands or to actively participate in actions necessary to manage exposures in the event of a default. And large buy-side firms, in particular, pension funds, do not currently meet all the requirements for direct membership.4 Pension fund participation is especially important because these institutions are on one side of a large proportion of repo transactions. CDCC and its members are already working to find a way for both of these groups to participate. CDCC is considering how to set up a mechanism that would allow smaller firms to clear indirectly – that is, through a direct member that provides clearing services. This is a triedand-true approach, one that is well understood by financial institutions. In addition to fixed-income and repo transactions, CDCS centrally clears options and futures traded on the MX and over-the-counter (OTC) equity options. P. Chatterjee, L. Embree and P. Youngman, “Reducing Systemic Risk: Canada’s New Central Counterparty for the Fixed-Income Market,” Bank of Canada Financial System Review (June 2012): 43–49. The current CDCS participants are: Bank of Montreal, CIBC World Markets Inc., Desjardins Securities Inc., Merrill Lynch Canada Inc., Morgan Stanley Canada Limited, National Bank of Canada, NBCN Inc., RBC Dominion Securities Inc., Royal Bank of Canada, Scotia Capital Inc., and Toronto-Dominion Bank. CDCS participants must be either a member in good standing of an exchange recognized in a Canadian province, or a bank to which the Bank Act (Canada) applies. Pension funds generally do not fall into either of these categories. BIS central bankers’ speeches Current CDCS participants have a role to play in facilitating this initiative. They need to consider whether or not to provide clearing services to smaller institutions and, if they choose to do so, to develop the capacity to take on this business. They will also need to determine how to manage their exposure to their customers. For large pension funds, indirect membership may not be a viable option, given the concentration of risk that would result if these entities cleared through a single direct participant. CDCC and the industry are examining an approach that would allow these entities to directly participate in the CCP in such a way that risk is managed without requiring them to be subject to the same mutualized loss-sharing arrangements. It is important that efforts to determine the exact details of how this arrangement could work in practice be pursued. The Bank of Canada strongly supports the work currently being undertaken by CDCC and the Investment Industry Association of Canada to increase participation in the CCP. The Bank will continue to be involved to ensure that the solutions put in place meet our high standards for risk management. While there are costs to participate in CDCS, the benefits are substantial, and they are reaped in both normal times and in times of stress. Not only will the Canadian financial system benefit from more repos being centrally cleared, but both current and future participants will benefit from increased netting efficiencies and reduced counterparty credit risk. These benefits will be further enhanced as the industry develops a generalized collateral repo product, in which any security in a predetermined basket of instruments can serve as collateral. This product should increase the liquidity and efficiency of the Canadian repo market. The Central Clearing of OTC interest rate derivatives is increasing Let me now turn to another effort to strengthen financial stability through the use of CCPs. I’m sure you are all well aware of the G-20 leaders’ commitment that all standardized overthe-counter (OTC) derivatives be cleared through CCPs. Canadian authorities, like those of most member countries of the Financial Stability Board (FSB), decided last autumn that we would allow our institutions to meet the G-20 commitment by using any CCP recognized by Canadian authorities, including global CCPs.5 While a CCP in Canada would provide the most straightforward oversight and capacity for Canadian authorities to intervene to mitigate risks, if needed, there are many advantages to the global solution. Global CCPs better promote liquidity and efficiency in what is largely a global OTC derivatives market. A global CCP makes the financial system more robust to shocks and allows derivatives users to appropriately manage their risk.6 The result though is that, globally, there will likely be a concentration of transactions in a small number of CCPs – these are truly becoming international systemically important financial institutions. To address this concentration of risk and to ensure that local authorities have the tools needed to protect local markets, the FSB developed safeguards for global clearing. These safeguards mean that global CCPs must: • provide fair and open access; This does not preclude the development and use of a local CCP in the future. See the December Financial System Review for more details on the analysis: http://www.bankofcanada.ca/ wp-content/uploads/2012/12/fsr-1212-chande.pdf. BIS central bankers’ speeches • be subject to effective co-operative oversight arrangements; • have robust recovery and resolution plans; and • have access to emergency liquidity in all relevant currencies. Now, when it comes to OTC derivatives, the most systemically important market for Canada is the interest rate derivatives market; and the largest global CCP for this market is LCH. Clearnet’s SwapClear service, located in London. The Bank is satisfied with the progress being made to implement the safeguards for SwapClear and has joined a multilateral arrangement for oversight co-operation put in place on 14 December 2012 by the U.K. Financial Services Authority. To be clear, the safeguards have not yet been fully achieved, in particular the development of recovery and resolution regimes for CCPs. Going forward, authorities in Canada will monitor the implementation of the safeguards in any CCP that becomes important to the stability of Canadian OTC derivatives markets. Canadian institutions have steadily moved their interest rate derivatives transactions to SwapClear.7 We expect this trend to continue as Canadian banks satisfy the G-20’s commitment to central clearing. Indeed, the progress is such that the Bank of Canada now considers SwapClear to be systemically important, and it will become subject to Bank oversight as of 2 April. Designation, which the Minister of Finance agrees is in the public interest, gives the Bank the authority and responsibility to assure itself that SwapClear has appropriate and effective risk controls in place. The Bank believes that the combination of co-operative oversight of SwapClear and the tools that come with designation will provide the Bank with the ability to effectively control systemic risk within this critical market and thereby improve the resilience of the Canadian financial system. Holding financial market infrastructures to more stringent risk-management standards The last area of reform that I want to discuss today is the new risk-management standards for systemically important financial market infrastructures. In 2010, the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) initiated a complete review of their risk-management standards. The goal was to make the standards consistent with current best practices and to reflect the experience of authorities in applying them, taking into account lessons learned from the financial crisis. The resulting Principles for Financial Market Infrastructures were finalized last year. The new standards are considerably more stringent than the previous ones and sharpen the focus on the control of systemic risk. They place a stronger emphasis on governance, and require FMIs to have comprehensive risk-management frameworks in place and to hold substantially more financial resources. The Bank of Canada has adopted these Principles and will apply them to the FMIs that it oversees.8 All FMIs – including those in Canada – will need to make improvements to their riskmanagement practices to meet the new standards. At the moment, each designated FMI is The Big Five Canadian banks are direct clearing members at SwapClear. In addition to CDCS, the Bank oversees the Large Value Transfer System (LVTS), Canada’s main electronic funds-transfer system; CDSX, Canada’s securities settlement system and central securities depository; and the Canadian-dollar leg of CLS Bank, which is a global payment system for the settlement of foreign exchange transactions, including those involving the Canadian dollar. BIS central bankers’ speeches undertaking a rigorous analysis of its practices against the new Principles, identifying gaps and developing plans to address them. The Bank and other Canadian regulators are working closely with FMIs to ensure timely compliance. What this means for participants, for you and your firms, is that there will be changes in the FMI’s risk-management practices as they move to meet the new standards. New riskmanagement practices will mean higher costs for FMIs which will have an impact on participants. In some cases, there will also be higher collateral requirements, but there will be greater assurance that transactions are carried out according to the wishes of participants, in good times and in bad. FMIs will inform their participants of upcoming changes as they work out the details. We are on our way, but we’re not there yet So where does this leave us? Emerging from the crisis, a key element of international reforms to strengthen the financial system was to reinforce FMIs. The goal is to reduce systemic risk and keep essential markets continuously open. In Canada, we have made much progress by creating a CCP for fixed-income repos and by substantially increasing the share of the OTC derivatives interest rate market that is centrally cleared. As well, we are putting in place new, more rigorous international standards for our FMIs. It is impressive how much has been accomplished, but there is more to be done. We recognize that many of the improvements involve costs, in both time and money, for the financial services sector. I do not want to understate the commitment this requires from all stakeholders. But the benefits will greatly outweigh the costs. And now is not the time to stop or slow down. It is essential to continue to invest in financial market infrastructure. With continued investments, we will have the assurance that FMIs will serve us well in the future. BIS central bankers’ speeches
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 17 April 2013.
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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 and Chairman of the Financial Stability Board, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 17 April 2013. * * * 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. • Global economic growth has evolved broadly as anticipated in January. • In the United States, the economic expansion is continuing at a modest pace, with gradually strengthening private demand partly offset by accelerated fiscal consolidation. • Significant policy stimulus has been introduced in Japan. • Europe, in contrast, remains in recession, with economic activity constrained by fiscal austerity, low confidence and tight credit conditions. • After picking up to very strong rates in the second half of 2012, growth in China has eased. • Commodity prices received by Canadian producers remain elevated by historical standards and, despite recent volatility, overall they are little changed since January. • The Bank expects global economic activity to grow modestly in 2013 before strengthening over the following two years. • Following a weak second half of 2012, growth in Canada is projected to regain some momentum through 2013 as net exports pick up and business investment returns to more solid growth. • Consumer spending is expected to grow at a moderate pace over the projection horizon, while residential investment declines further from historically high levels. Growth in total household credit has slowed and the Bank continues to expect that the household debt-to-income ratio will stabilize near current levels. • Despite the projected recovery in exports, they are likely to remain below their prerecession peak until the second half of 2014 owing to restrained foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. • On a quarterly basis, growth in Canada is expected to pick up to about 2.5 per cent in the second half of this year. Despite this expected pickup, with the weak growth in the second half of 2012, annual average growth is now projected to be 1.5 per cent in 2013. The economy is then projected to grow by 2.8 per cent in 2014 and 2.7 per cent in 2015, reaching full capacity in mid-2015. This is later than anticipated in January. • Total CPI and core inflation have remained low in recent months, broadly in line with expectations in January. Muted core inflation reflects material excess supply in the economy, heightened competitive pressures in the retail sector, and some special factors. Total CPI inflation has been restrained by low core inflation and declining mortgage interest costs, with some offset from higher gasoline prices. • Both total and core inflation are expected to remain subdued in coming quarters before gradually rising to 2 per cent by mid-2015 as the economy returns to full BIS central bankers’ speeches capacity, the special well-anchored. factors subside, and inflation expectations remain • The inflation outlook in Canada is subject to upside and downside risks, which are similar to those identified in January. • The three main upside risks relate to the possibility of stronger-than-expected growth in the U.S. and global economies, a sharper-than-expected rebound in Canadian exports, and renewed momentum in Canadian residential investment. • The three main downside risks relate to the European crisis, more protracted weakness in business investment and exports in Canada, and the possibility that growth in Canadian household spending could be weaker. • Overall, the Bank judges that the risks are roughly balanced over the projection horizon. • Reflecting all of these factors, the Bank today maintained the target for the overnight rate at 1 per cent. • With continued slack in the Canadian economy, the muted outlook for inflation, and the constructive evolution of imbalances in the household sector, the considerable monetary policy stimulus currently in place will likely remain appropriate for a period of time, after which some modest withdrawal will likely be required, consistent with achieving the 2 per cent inflation target. 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 and Chairman of the Financial Stability Board, before the House of Commons Standing Committee on Finance, Ottawa, 23 April 2013.
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Mark Carney: Opening statement before the House of Commons Standing Committee on Finance – April Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, before the House of Commons Standing Committee on Finance, Ottawa, 23 April 2013. * * * Good morning. Tiff and I are pleased to be here with you today to discuss the April Monetary Policy Report, which the Bank published last week. • Global economic growth has evolved broadly as anticipated in January. • In the United States, the economic expansion is continuing at a modest pace, with gradually strengthening private demand partly offset by accelerated fiscal consolidation. • Significant policy stimulus has been introduced in Japan. • Europe, in contrast, remains in recession, with economic activity constrained by fiscal austerity, low confidence and tight credit conditions. • After picking up to very strong rates in the second half of 2012, growth in China has eased. • Commodity prices received by Canadian producers remain elevated by historical standards and, despite recent volatility, overall they are little changed since January. • The Bank expects global economic activity to grow modestly in 2013 before strengthening over the following two years. • Following a weak second half of 2012, growth in Canada is projected to regain some momentum through 2013 as net exports pick up and business investment returns to more solid growth. • Consumer spending is expected to grow at a moderate pace over the projection horizon, while residential investment declines further from historically high levels. Growth in total household credit has slowed and the Bank continues to expect that the household debt-to-income ratio will stabilize near current levels. • Despite the projected recovery in exports, they are likely to remain below their prerecession peak until the second half of 2014 owing to restrained foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. • On a quarterly basis, growth in Canada is expected to pick up to about 2.5 per cent in the second half of this year. Despite this expected pickup, with the weak growth in the second half of 2012, annual average growth is now projected to be 1.5 per cent in 2013. The economy is then projected to grow by 2.8 per cent in 2014 and 2.7 per cent in 2015, reaching full capacity in mid-2015. This is later than anticipated in January. • Total CPI and core inflation have remained low in recent months, broadly in line with expectations in January. Muted core inflation reflects material excess supply in the economy, heightened competitive pressures in the retail sector, and some special factors. Total CPI inflation has been restrained by low core inflation and declining mortgage interest costs, with some offset from higher gasoline prices. • Both total and core inflation are expected to remain subdued in coming quarters before gradually rising to 2 per cent by mid-2015 as the economy returns to full BIS central bankers’ speeches capacity, the special factors subside, and inflation expectations remain wellanchored. • The inflation outlook in Canada is subject to upside and downside risks, which are similar to those identified in January. • The three main upside risks relate to the possibility of stronger-than-expected growth in the U.S. and global economies, a sharper-than-expected rebound in Canadian exports, and renewed momentum in Canadian residential investment. • The three main downside risks relate to the European crisis, more protracted weakness in business investment and exports in Canada, and the possibility that growth in Canadian household spending could be weaker. • Overall, the Bank judges that the risks are roughly balanced over the projection horizon. • Reflecting all of these factors, on 17 April, the Bank maintained the target for the overnight rate at 1 per cent. • With continued slack in the Canadian economy, the muted outlook for inflation, and the constructive evolution of imbalances in the household sector, the considerable monetary policy stimulus currently in place will likely remain appropriate for a period of time, after which some modest withdrawal will likely be required, consistent with achieving the 2 per cent inflation target. 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 and Chairman of the Financial Stability Board, at the bank note unveiling, Ottawa, Ontario, 30 April 2013.
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Mark Carney: Canada’s latest Polymer bank notes Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, at the bank note unveiling, Ottawa, Ontario, 30 April 2013. * * * I am pleased to welcome you today for the unveiling of the last two bank notes in our new Polymer series, the $5 and $10 bank notes. One of the critical elements of the Bank of Canada’s mandate is the design, production and distribution of bank notes that Canadians can use in complete confidence for their day-to-day transactions. It is therefore very important for the Bank to keep ahead of counterfeiters who undermine this confidence. We made considerable progress in the fight against counterfeiting even before the release of the polymer bank notes. In 2012, for example, the rate of counterfeiting had dropped by 92 per cent from its peak in 2004. These new bank notes offer increased security and will contribute to a further reduction in counterfeiting rates. Almost half a billion of these new notes are now in circulation. Safer, cheaper, greener, the polymer notes have already proven their worth. Safer, because all the notes have the same state-of-the-art security features, using holography, transparency and other elements that make them difficult to counterfeit but easy for everyone, especially those behind the counter, to verify. Cheaper, because the durable polymer material lasts at least 2.5 times longer than paperbased notes. This means that fewer notes will need to be printed, making the series more economical. Greener because, over the life of the series, fewer notes produced also means fewer notes transported. And when they do need to be replaced, the notes will be recycled in Canada. As we all know, these polymer bank notes look and feel different than the paper-based currency of the past. This has been a big change for everyone: the Canadian public, financial institutions, retailers and the manufacturers of bank-note-handling equipment. The Bank of Canada will continue to work closely with all of these groups through this transition. The $5 and $10 bank notes that we are unveiling today will make their début in November, and in the coming months, businesses can begin to prepare for the switch and upgrade their cash-handling machines. The innovative nature of the polymer notes is echoed in the theme of the series – frontiers – because, in so many ways, these notes break new ground. The “frontiers” theme is also reflected in the images chosen to grace these notes. Each denomination represents the best of Canada: scientific discovery on the $100 note, Arctic research on the $50 and valour and sacrifice on the $20. The bank notes we unveil today continue this tradition. The $10 note depicts a great feat of engineering from Canada’s past – the joining of East and West by rail. The $5 note highlights Canada’s technological achievements that look skyward – our contributions to the international space program. As Governor of the Bank of Canada, I join all my colleagues to express our pride in these new bank notes, also a product of great technological innovation. They are the impressive result of teamwork and dedication by chemists, physicists, researchers, artists and analysts. This kind of synergy, which is at the heart of excellence, has been a hallmark of our nation throughout its history. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Board of Trade of Metropolitan Montreal/Chambre de commerce du Montréal métropolitain (CCMM), Montreal, Quebec, 21 May 2013.
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Mark Carney: Canada works Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the Board of Trade of Metropolitan Montreal/Chambre de commerce du Montréal métropolitain (CCMM), Montreal, Quebec, 21 May 2013. * * * Introduction It is almost six years since the start of the global financial crisis, and its dynamics still dominate the economic outlook. In the United States, households are emerging from a painful period of deleveraging. Their economic expansion continues at a modest pace, with gradually strengthening private demand partly offset by accelerated fiscal consolidation. Despite recent progress, the U.S. economy has not yet achieved escape velocity. Europe remains in recession, with economic activity constrained by fiscal austerity, low confidence and tight credit conditions. Deep challenges persist in its financial system. Without sustained and significant reforms, a decade of stagnation threatens. Europe can draw lessons from Japan on the dangers of half measures. It is now more than two decades since the Japanese financial crisis erupted. To end its debilitating legacy, Japan has just embarked on a bold policy experiment. Its success or failure will have a major impact on the outlook over the coming years. Amongst the G-7, Canada is unique. For us, the global financial crisis was an external rather than internal shock. When Canadian policy-makers responded quickly and forcefully, our financial system channelled credit to where it was needed and our economy adjusted smartly. As painful as our recession was, Canada suffered less. By the start of 2011, all of the output and all of the jobs lost during the recession had been recovered (Charts 1 and 2). A further 480,000 jobs have been created since, with the vast majority of them full-time and in the private sector. Nearly all the new jobs are in industries that pay above-average wages. Relative to our peers, Canada is working. Why did we fare better? Our outperformance reflects four critical advantages: • responsible fiscal policy, • sound monetary policy, • a resilient financial system, and • a monetary union that works. I will discuss these foundations of our prosperity in more detail, but I don’t intend to oversell them. These are the cornerstones of Canada’s prosperity, but lasting growth depends on what is built on this foundation through longer-term investments in infrastructure, human capital, innovation and new markets. A monetary union that works Canada’s monetary union has the essential elements of an effective currency union: an integrated economy, fiscal federalism and labour market flexibility. Allow me to elaborate. BIS central bankers’ speeches An integrated economy While the composition of provincial output varies, the Canadian economy is highly integrated. Consider the case of commodities. When commodity prices increase, all provinces benefit. All else equal, the Canadian dollar appreciates. Its adverse impact on our non-commodity exports is partially offset by the fact that a stronger currency reduces the cost of productivity-enhancing machinery and equipment and imported inputs to production.1 Various mechanisms distribute benefits across provinces: fiscal policy; increases in personal wealth through income and ownership of stock; and movements in internal real exchange rates and interprovincial trade.2 During the recession and its aftermath, the importance of interprovincial trade was clear. For example, the increased demand from other provinces for Quebec’s goods and services significantly offset lost international exports (Chart 3). Movements in provincial real exchange rates are another important part of the adjustment process. Although there is one exchange rate for Canada as a whole (we all use Canadian dollars), price differentials across the country yield different real provincial exchange rates. This matters. Consider the Alberta/Quebec real exchange rate (Chart 4). When higher energy prices stimulate production and investment in Alberta, extraction, construction and labour costs there rise. This increases the real Alberta exchange rate, making goods and services from the other provinces, including Quebec, more competitive. Interprovincial trade is boosted, spreading benefits from energy price increases throughout the economy. It is interesting to compare developments in the Canadian and European internal exchange rates. For example, since the euro was introduced, Spanish competitiveness (as measured by GDP deflators) has fallen by about 30 per cent relative to Germany. During the same period, the Alberta exchange rate moved even more dramatically, rising 40 per cent relative to Quebec (Chart 5). Intra-regional exchange rates in Canada have generally been more volatile on average than most internal exchange rates in the euro area (See Tables 1 and 2, Appendix). And yet, the challenges of regaining competitiveness are central to the economic travails of Spain. This is because Spain is experiencing a balance of payments crisis. In the years following monetary union, Spain ran large intra-euro-area current account deficits, funded in part by foreign purchases of real estate and inflows to the Spanish banking system. When these dried up, domestic activity collapsed. There are few institutional mechanisms within the Economic and Monetary Union (EMU) at present to offset the shock. In Alberta’s case, a rising tide has lifted all boats. That is because the Canadian monetary union has what Europe does not: a single financial market; a flexible, national labour market; and significant fiscal transfers. These smooth the adjustments brought about by the large shifts in relative prices. Fiscal federalism helps to share risks Despite the equilibrating movement of real provincial exchange rates, shocks to our economy can still have a more significant impact on some regions than others. Since monetary policy works at an aggregate level to support aggregate demand, it cannot easily deal with such distributional consequences. M. Carney, “Dutch Disease,” a speech delivered at the Spruce Meadows Round Table, Calgary, Alberta, 7 September 2012. Internal trade has been supported by the removal of interprovincial barriers following the implementation of Canada’s Agreement on Internal Trade in 1995. BIS central bankers’ speeches Fiscal transfers are thus an important element of a successful monetary union. They are sizeable in Canada, representing 8 per cent of GDP across all levels of government (Charts 6 and 7). Canada’s equalization program helps stabilize the impact of asymmetric shocks. For example, between 2006 and 2011, federal support programs, including equalization payments and Canadian social and health transfers, grew more rapidly for provinces whose economies were hardest hit by the crisis (Chart 8).3 The Employment Insurance program also shares risk. Through transfers to 2 per cent of the working-age population, the program particularly benefits provinces with higher unemployment rates (Chart 9). In the medium term, one of the building blocks of European fiscal federalism could be a panEuropean employment insurance scheme built on a common European labour market. This would reduce impediments for those looking across the continent for work, while providing a cross-country automatic stabilizer. Labour market flexibility For Canada and Canadians to work, workers must be able to move to different jobs, and wages must adjust to help maintain full employment. By international standards, the Canadian labour market is highly flexible, although there is still room for improvement.4 Our labour mobility as a whole is similar to that in the United States. By some estimates, the Canadian labour market is almost four times as flexible as the European labour market.5 An obvious example of this flexibility is the way that Canadians have responded to the higher wages and employment opportunities in the energy sector. Last year, there was a net inflow of more than 40,000 people into Alberta from the rest of Canada, a level of mobility that approaches its previous peak (Chart 10). As a consequence, labour markets are becoming more similar across the provinces. In particular, the dispersion of employment rates in Canada has fallen steadily over the past 30 years to levels comparable with those in the United States. Again the contrast with Europe, where it has risen substantially, is striking (Chart 11). The amount of transfers to Alberta has been adjusted to exclude a one-time cash increase occurring in 2007–08 which resulted from a transitional change toward a per capita cost allocation. The decline in fiscal support for Newfoundland and Labrador is due to the fact that the province no longer qualifies for equalization payments (as of 2008/9). D. Amirault, D. de Munnik and S. Miller, “Explaining Canada’s Regional Migration Patterns,” Bank of Canada Review (Spring 2013): 16–28. Based on the 2006 Census, the migration rate in Canada was 4.6 per cent compared with 4.8 per cent for the United States. Bayoumi et al. (2006) find that Canadian labour markets respond in a similar manner to their U.S. counterparts and are more flexible than those in major euro-area countries, while Partridge and Rickman (2009) find little overall evidence to suggest that provincial labour markets are more sluggish or less flexible than U.S. state labour markets. A recent report by McKinsey & Company shows that cross-border labour mobility in the European Union is low (0.18 per cent in 2008). See T. Bayoumi, B. Sutton and A. Swiston, “Shocking Aspects of Canadian Labor Markets,” International Monetary Fund Working Paper 06/83, March 2006; M. Partridge and D. Rickman, “Canadian Regional Labour Market Evolutions: A Long-Run Restrictions SVAR Analysis,” Applied Economics, Taylor and Francis Journals, vol. 41(15), p. 1855–71, 2009; and F. Mattern, E. Windhagen, M. Habbel, J. Mu?hoff, H-H. Kotz and W. Rall, The Future of the Euro, An Economic Perspective on the Eurozone Crisis, McKinsey & Co., January 2012. BIS central bankers’ speeches Bank of Canada research suggests that the main reason behind these improvements has been the increased sensitivity of provincial population growth to labour market opportunities – Canadians are going where the jobs are.6 Finally, wages are flexible in Canada. Results from the Bank of Canada’s wage setting survey indicate that, while firms are typically reluctant to reduce base wages, incentive pay offers a possible source of downward flexibility in total compensation.7 About 90 per cent of Canadian private sector firms currently use short-term incentive pay plans.8 Such risk sharing is an effective way to maintain employment and profitability during uncertain and volatile times. A resilient financial system An important lesson from Europe’s experience is the critical role that a sound financial system plays in the monetary policy transmission mechanism. It helps to ensure that changes in central bank policy are transmitted effectively to all regions to support growth and employment. When a sizeable share of a country’s banking sector has (or is perceived to have) deficient capital and liquidity positions, credit doesn’t flow to where it is needed. Recent experience in Europe has shown the particular problems a monetary union faces when banks become less willing to lend across borders within the union. This fragmentation has reinforced the links between sovereign and bank solvency. As European leaders now recognise, without major reforms to create a banking union, EMU is fundamentally weakened. In Canada, the existence of largely centralized prudential regulation and deposit insurance pools risk across the country. When combined with a large number of national banking institutions, this greatly reduces the risk that localized economic and financial disruptions impair provincial solvency. Since the strength of the Canadian banking system has been well documented, I will concentrate on Canada’s sound regulatory framework. Its key elements are: First, supervision is focused and proactive. Consolidated prudential supervision is not burdened by other objectives such as the promotion of home ownership or community reinvestment. The staged intervention approach of the Office of the Superintendent of Financial Institutions (OSFI) means it works with institutions to correct problems at an early stage, while they are still manageable. Second, efforts to promote financial stability are coordinated. Federal authorities consistently share information, coordinate actions, and pool advice to the federal government on financial sector policy. Most notable in this regard has been a series of actions to slow the rate of increase in household debt. The Bank of Canada also works with provincial authorities to implement a number of global initiatives. Third, Canada has clear and credible recovery and resolution mechanisms, including lenderof-last-resort policies, a deposit insurance scheme with risk-weighted premiums, and bridgebanking powers that enable the rapid closure of failing institutions and the swift re-opening of their viable operations. In its most recent budget, the federal government announced it will consult stakeholders on how best to implement a bail-in regime to recapitalize failing D. Leung and S. Cao, “The Changing Pace of Labour Reallocation in Canada: Causes and Consequences,” Bank of Canada Review (Summer 2009): 31–41. D. Amirault, P. Fenton and T. Laflèche, “Asking About Wages: Results from the Bank of Canada’s Wage Setting Survey of Canadian Companies,” Bank of Canada Discussion Paper 2013-1, February 2013. Conference Board of Canada, Compensation Planning Outlook 2013, October 2012. BIS central bankers’ speeches Canadian banks that are systemically important to our domestic economy through the very rapid conversion of certain bank liabilities into regulatory capital. Fourth, bank capital regulation is prudent. Prior to the crisis, Canadian capital requirements were higher than international norms thanks to OSFI’s insistence that common equity form a large share of required capital. Since the crisis, Canadian banks have become considerably stronger. Their common equity capital has increased by 80 per cent, or $77 billion, and they already meet the new Basel III capital requirements six full years ahead of schedule. Finally, the entire financial framework is regularly reviewed and updated, in accord with the statutory requirement to renew the federal 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’s regulatory system is subject to regular, rigorous external examinations. A massive and disciplined policy response Allow me to review. The structure of the Canadian economy, the risk sharing across the federation, labour market flexibility and financial stability together meant that Canada could adjust quickly to the shock of the global financial crisis. It also meant that when Canadian policy-makers responded, they were able to do so swiftly and massively. During the crisis, the Bank of Canada aggressively cut our policy rate until it reached onequarter of one per cent, the lowest it can effectively go. The Bank then provided extraordinary guidance on the likely path of interest rates necessary to achieve the inflation target in order to maximise the monetary stimulus from its policy rate. Canada’s inflation-targeting regime was a critical anchor during those turbulent times. It gave the Bank a simple, unwavering goal to guide its policy actions. It provided financial markets and Canadians with a clear means to understand why the Bank did what it did. And that understanding kept inflation expectations well anchored around the 2 per cent target throughout the period, maximising the stimulative impact of our policies. Although fiscal policy is always less nimble than monetary policy, it also responded aggressively. Government expenditures rose by almost 3 percentage points of GDP within a year, with government contributing about one-third of GDP growth in 2010 (Chart 12). The effectiveness of fiscal policy was underpinned by Canada’s strong fiscal position. From the mid-1990s onwards, successive governments ran more than a decade of surpluses, cutting the government debt-to-GDP ratio from almost 70 per cent in 1995 to 22 per cent in 2008. As a result, Canada’s net debt relative to GDP went from being the second-highest ratio among the G-7 countries in 1995 to the lowest (Chart 13). This fiscal flexibility provided leeway for governments to respond while maintaining our credit standing at the highest levels. Having clear policy frameworks has disciplined the post-crisis response. Fiscal consolidation has begun, with the combined deficits of all levels of government falling from 4.8 per cent in 2009 to an expected 2.8 per cent this year.9 Disciplined by its inflation target and reflecting the relative strength of the economy, the Bank of Canada was the only G-7 central bank not to engage in quantitative easing, and we have been the only one to move away from emergency settings of interest rates. In addition, mindful of the risks to financial stability arising from rapid increases in household debt, the International Monetary Fund, Fiscal Monitor, Statistical Table 1, April 2013. BIS central bankers’ speeches Bank has maintained a tightening bias on interest rates over the past year, in part to complement efforts of the federal government and OSFI to achieve a constructive evolution of household debt. Conclusion In the immediate aftermath of the crisis, the broad economic strategy in Canada has been to grow domestic demand and to encourage Canadian businesses to retool and reorient to the new global economy. Stimulative monetary and fiscal policies proved highly effective in supporting robust growth in domestic demand, particularly household expenditures, which grew to record levels. As effective as it has been, the limits of this growth model have been clear for some time. We cannot grow indefinitely by relying on Canadian households increasing their borrowing relative to income (Chart 14). Nor can residential investment remain near a record share of GDP, particularly given signs of overbuilding and overvaluation in segments of the real estate market. Domestic demand, which pulled Canada out of the recession, is now slowing. Consumer spending is expected to grow at a moderate pace over the next few years. The Bank expects residential investment to decline further from historically high levels. The contribution of direct government expenditures should be modest for some time, consistent with the ongoing need to consolidate budgetary positions. Thus, the challenge for Canada is to rotate the sources of growth toward net exports and business investment. Exports are currently more than $130 billion less than they would have been had this been a “typical” postwar recovery (Chart 15). In the short term, the Bank forecasts some rebalancing and a pickup in real GDP growth. However, relative to previous cycles, investment is expected to remain below average and the contribution of net exports to be very weak (Chart 16). Is that really the best we can do? Yes, there are immense uncertainties in the world economy, but we need to focus on what we can control. We cannot save the euro or fix America’s fiscal challenges. Should we just wait out a decade-long deleveraging process in the rest of the G-7? Or should we control our destiny by building on our strengths in the new global environment? To find and compete in new markets will require a concerted, multi-year effort by workers, firms and governments. These efforts should be guided by three principles. Openness is better than protectionism. Trade brings innovation, growth and jobs. That is why Canada is pursuing a series of bilateral trade discussions with economies such as the European Union and India, and will participate in the multilateral negotiations of the TransPacific Partnership involving a number of Asian countries. Emerging-market economies do not just account for one-half of all of global import growth, they also are essential to securing Canada’s positions in global supply chains. 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. This means we must continuously invest in our workforce. With technology and trade transforming the workplace, the need to improve skills across the spectrum of work has never been greater. Sound macroeconomic policy is the cornerstone of prosperity. Fiscal profligacy erodes economic sovereignty; price stability is paramount. BIS central bankers’ speeches The advantages I have discussed today are self-reinforcing. Our monetary union – with its resilient, national financial system at its core – gives monetary and fiscal policy traction. A strong fiscal position means that Canadian governments have had the flexibility to respond as needed. Our principles-based macroeconomic policy frameworks help ensure that extraordinary actions do not give rise to extraordinary fears. And the discipline they instil means that stimulus will be withdrawn appropriately as threats diminish. All of this has meant that, unlike the rest of the G-7, Canada does not need to repair. To keep Canada working, we need to build. 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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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, before the House of Commons Standing Committee on Finance, Ottawa, Ontario, 6 June 2013.
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Stephen S Poloz: Opening statement before the House of Commons Standing Committee on Finance Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, before the House of Commons Standing Committee on Finance, Ottawa, Ontario, 6 June 2013. * * * Introduction The Bank of Canada’s commitment to Canadians is to promote the economic and financial welfare of our country. One way we do this is to communicate our objectives openly and effectively and stand accountable for our actions. So I thank you for the opportunity to come before you this morning to share the Bank’s perspective. Kindly note that today is day four on the job for me – I trust you will forgive me if there are any details I haven’t yet become familiar with. That said, I look forward to hearing your views and taking your questions, and I will answer them to the best of my ability. The common denominator that ties together all of the Bank’s work is confidence. Through our actions and our words, what the Bank of Canada delivers is confidence in our currency; confidence in our role as fiscal agent for the federal government; confidence in our banking system; and confidence in the value of money. This is familiar ground to all of us here today. I don’t propose to delve into the details of the Bank’s functions. Rather, I will discuss the current context in which we are operating and how that is influencing the Bank’s work of delivering confidence. In short: what are the challenges that we are facing? And, how do they affect the business of the Bank? Today's global context It is now almost six years since the start of the global financial crisis. Given the near-collapse of the global financial system and the dramatic plunge in global demand, it’s perhaps no surprise that we haven’t yet returned to normal economic conditions. The global economy continues to struggle. Most advanced economies are still facing credit stresses and record-low interest rates. Many central banks continue to use unconventional means to provide stimulus, and governments are doing everything they can to manage their respective debt situations. Clearly, the global economy is still in recovery. Global economic activity is expected to grow modestly this year before strengthening over the following two years. But this is not a recovery in the usual sense. It’s more like a postwar reconstruction. It will require sustained and focused efforts to rebuild global economic potential. Allow me to talk about how, in this context, the Bank of Canada delivers confidence. Delivering confidence Delivering confidence in our currency Let me start with confidence in our currency which, for many Canadians, is our most tangible work. Every bank note in the wallets of Canadians is the product of specialized and sophisticated expertise. We have nearly 200 people – physicists, chemists, engineers and other experts – who design, test and distribute bank notes across Canada. We also communicate with retailers, financial institutions and the public, and work with law enforcement to deter counterfeiting. BIS central bankers’ speeches The stakes are high when it comes to counterfeiting, not only in direct losses to Canadians, but also the loss of confidence that it creates in the use of bank notes. The challenge of counterfeiting is significant. There was a time, in 2004, when counterfeiting in Canada was at a historic peak – and high by international standards. I’m sure many of you remember seeing signs posted in stores saying that $100 or $50 bank notes were not accepted. The Bank of Canada introduced enhanced security features and worked closely with lawenforcement agencies, the RCMP, and the courts, as well as financial institutions and retailers, to bring those counterfeiting rates down. And we succeeded. Even before the introduction of our new polymer bank notes, counterfeiting rates had been reduced by 90 per cent. But it’s important to remember that staying ahead of counterfeiters is a constant challenge. We must always be proactive. That is why the Bank launched a new series of polymer bank notes that are safer, cheaper, and greener. Safer, because of sophisticated security features, including holography and transparency, that make these new notes harder to counterfeit and easier to verify. Cheaper, because they last at least 2.5 times longer than paper-based notes. This means that fewer notes will need to be printed, making the series more economical. And greener, because over the life of the series, fewer notes produced means fewer notes transported. And when they do need to be replaced, the notes will be recycled in Canada. With these new notes, Canadians can have full confidence in their currency. Delivering confidence in our funds management The second area of our focus is much less visible to most Canadians. As the fiscal agent of the federal government, the Bank of Canada provides advice and administers the government’s debt and reserves – and demonstrates global leadership in these realms. Innovative work is being done, for example, to reduce the reliance on external credit-rating agencies in the management of the government’s assets and liabilities. There is a lot of money at stake. In 2012, the Bank managed Government of Canada daily cash balances averaging about $17 billion. We also managed, on behalf of the government, official international reserves amounting to about US$69 billion. Delivering confidence in our financial system As with any plumbing system, we tend to take notice only when things go wrong. Through the crisis and since, the Bank’s work has meant that the resilience of Canada’s payment clearing and settlement system has been maintained at a very high level, ensuring that Canadians can have confidence that the economy is supported by solid financial market infrastructures. Financial stability at home is necessary, of course, but not sufficient. The crisis made it abundantly clear that the global financial system needed remodelling – and the Bank of Canada has been at the forefront of global reform work. Canada has also made good on our G-20 commitments. Among other reforms, we have put in place Basel III capital standards ahead of schedule. We have made significant strides on other market infrastructure reforms, which we can address in detail during our discussion. These are real accomplishments, and our financial system is stronger as a result. But we must not lose momentum, here in Canada or on the international stage. More work is required to end the phenomenon of institutions that are too big to fail, including recovery and resolution plans for banks. And countries need to address the issue of shadow banking to BIS central bankers’ speeches ensure that systemically important financial institutions operating outside the perimeter of regulation come broadly into line with their regulated counterparts. Delivering confidence in monetary policy Finally, confidence is clearly important for the conduct of monetary policy. Monetary policy in Canada is supported by a governance structure that instills confidence and ensures that Canadians, through their government, have a say in setting the monetary policy framework. Importantly, the structure also ensures the independence of the central bank to make the right policy decisions to achieve our inflation target. Canada’s monetary policy framework is a good one. After a tremendous amount of research, Canada adopted an inflation-targeting regime in 1991. Since 1995, the target has been 2 per cent. We recognized early on that a commitment to hold inflation absolutely steady at 2 per cent was unrealistic. Shocks to the economy must be taken into account. So the framework is designed to keep total CPI inflation at the 2 per cent midpoint of a target range of 1 to 3 per cent over the medium term. It bears mentioning that the target is symmetrical. We care just as much about inflation falling below as we do about it rising above the target. The Bank raises or lowers its policy interest rate, as appropriate, in order to achieve the target typically within a horizon of six to eight quarters – the time that it usually takes for policy actions to work their way through the economy and have their full effect on inflation. Over the past couple of decades, the average rate of inflation has been very close to target. Even during the global economic and financial crisis, our commitment did not waver. The inflation target is sacrosanct to us and has become a credible anchor for the inflation expectations of Canadians. A key component of the Bank of Canada’s inflation-targeting framework is a flexible exchange rate. While the exchange rate is influenced by such variables as commodity prices, relative inflation rates, and relative interest rates, its value is determined in currency markets. The credibility earned by the Bank over the past twenty years allows us to take advantage of the flexibility inherent in the framework with respect to the amount of time it takes to return inflation to target. The recent turmoil tested the limits of our flexible inflation-targeting framework. Nonetheless, the inflation expectations of Canadians remain well anchored, proving that our framework is secure and working. But it also informs us that we need to validate those expectations to maintain our credibility. This brings me to a discussion of the domestic context. The context in Canada The severity of the global economic and financial crisis meant that the recession it triggered in Canada was different from any other postwar recession. Canada experienced a particularly deep contraction of investment and exports, as business confidence plummeted along with global demand. In the immediate aftermath of the crisis, stimulative monetary and fiscal policies proved highly effective in supporting robust growth in domestic demand, particularly household expenditures, which grew to record levels. Yet, as effective as it has been, with domestic demand now slowing, the limits of this growth model are clear. What’s less clear is the rebuilding process underlying the necessary rotation of growth toward net exports and business investment. While the Canadian economy as a whole has recovered from the recession, thanks to domestic demand, the depth and duration of the global recession delivered a direct, sharp blow to Canadian business. In many cases, temporary plant shutdowns were not sufficient to match the fall in demand. Some firms permanently downsized their operations. Others simply closed their doors. Large job losses resulted. BIS central bankers’ speeches In effect, the recession caused a significant structural change in the Canadian economy. The level of our country’s productive capacity – in other words, its potential – dropped, as the Bank noted in April 2009. Standard macroeconomic models don’t really capture these dynamics. Just as the financial crisis triggered an atypical recession, the recovery cycle is unusual. The rotation of demand will require more than just the ramping up of production. The sequence we can anticipate is the following: foreign demand will recover; our exports will strengthen further; confidence will improve; companies will invest to increase capacity; existing companies will expand and new ones will be created. In short, we need to see the reconstruction of Canada's economic potential, and a return to self-sustaining, self-generating growth. This sequence may already be underway. We are now seeing signs of recovery in some important external markets, notably the United States and Japan, and there is continued growth in emerging-market economies. The Bank expects that the gathering momentum in foreign demand should help lift the confidence of Canada’s exporters. This is critical for Canadian firms to boost their investment to expand their productive capacity. Conclusion – confidence in words, as well as actions The Bank has a role to play nurturing that process, to the extent possible within the confines of our inflation-targeting framework. There is no conflict between nurturing this and our need to get inflation up to the 2 per cent target. In monetary policy, actions are critically important, but words, too, matter a great deal. We can bolster confidence by explaining the forces at work in our economy, our projections for what’s ahead, and our monetary policy response. And we help nurture confidence by listening to businesses, to labour groups, and to industry associations in order to expand our understanding of what’s happening in the real economy. We must always remember that beneath our economic and financial statistics and analysis are real people, making real decisions that can lead to bad outcomes as well as good ones. Those decisions are hard to make any time, but when uncertainty is high and confidence has not been fully restored, they can be even more difficult. A lack of confidence can mean that such decisions are postponed – and that opportunities are lost. To help engender confidence, an active engagement with Canadians must be a cornerstone of the policy of the Bank of Canada, not least of which is a continuing dialogue with this committee. With that, I thank you for listening. I would be pleased to take your questions. BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Oakville Chamber of Commerce, Burlington, Ontario, 19 June 2013.
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Stephen S Poloz: Reconstruction – rebuilding business confidence in Canada Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Oakville Chamber of Commerce, Burlington, Ontario, 19 June 2013. * * * Introduction Thank you for that introduction and to all of you for coming today. It is a pleasure to deliver my first public speech as Governor of the Bank of Canada here in the heart of southern Ontario, especially since we are just down the road from my hometown of Oshawa. This region is a historic centre of Canadian industry and commerce. It is home to some of Canada’s most storied businesses and prestigious centres of learning. Many of the firms that made this region and Canada strong were on the front lines as the global financial crisis pushed the Canadian economy into recession. As our economy continues to expand, it will be the performance of the business sector here and across Canada over the coming while that we will be watching with great interest. That’s because what happens to business in Canada matters for the Bank of Canada. Not just because we care – which, let me assure you, we do. But in order for us to do our job properly, in order for us to promote the economic and financial welfare of Canadians, we need to understand all the dynamics that feed into the Canadian economy. The Bank aims to keep inflation low, stable and predictable. Our flexible inflation-targeting framework is the best contribution monetary policy can make so that Canadian households and businesses can make decisions about their financial futures with confidence. Over the past couple of decades, the average rate of inflation has been very close to our 2 per cent target. Even during the global economic and financial crisis, our commitment did not waver. The inflation target is sacrosanct to us and has become a credible anchor for the inflation expectations of Canadians. Moreover, the target is symmetrical: we care just as much about inflation falling below as we do about it rising above the target. When inflation falls below the target and interest rates are correspondingly low, there is little room for conventional monetary policy to respond to negative shocks. When inflation is above target, the erosion of purchasing power becomes significant and uncertainty about future prices makes it hard for households and businesses to make good financial decisions. Further, the framework has built-in flexibility with respect to the amount of time it takes to return inflation to target after a shock. Years of successful inflation targeting have given the Bank the credibility to use this flexibility during periods of economic stress. A flexible exchange rate is also key to achieving our inflation targets over time. The recent turmoil showed us the value of the credibility we have earned. Like others, to address the stresses of the crisis, we put the flexibility of our regime to work. Nonetheless, throughout the recession and since, the inflation expectations of Canadians have remained well anchored at the target, proving that our framework is secure and working. This past downturn was different from previous recessions. Even though Canada performed better than our G-7 peers, the Great Recession put many companies out of business, especially small and exporting firms. Many of those that survived dramatically reduced their operations, shuttering plants and dismantling equipment. These actions hurt – badly – in terms of job losses and lost output. While both have recovered – in fact, surpassed their pre-recession peaks – the structural damage caused by BIS central bankers’ speeches the crisis lingers. Indeed, our recovery has been primarily driven by higher household spending, while exports have lagged behind. Rather than a recovery in the usual sense, this looks more like a postwar reconstruction. Or, if you will allow me to slide into more academic language for a moment and refer to the Schumpeterian process of “creative destruction,” we’ve certainly had the destruction. But the creation side of the equation has been delayed by numerous unusual risks, heightened uncertainty, and a lack of confidence. This is what I want to talk about today. I want to discuss the impact of the crisis on Canadian business and how the firms that have survived have changed and are responding. We need business confidence to continue to heal. This matters very much to the Bank of Canada. Our understanding of these issues will be part of the rigorous distillation of information that drives our policy decisions. As part of the process, we meet, we talk, we argue and do our best to understand the significant forces driving the economy. With our next policy decision on 17 July, we are now at the early stage of this round. Standard macroeconomic models can only go so far in capturing today’s dynamics, and especially when uncertainty is greater than normal, it is important to supplement the models with insights directly from business. My messages today will be relevant for companies across Canada, but they resonate particularly in this region. As a native of Oshawa, I understand that well. I have seen the impact of the crisis and the recession on the auto sector in my hometown. I have heard about it from the manufacturers and exporters in this region. And the Bank has heard about it from the financial community on Bay Street and from all types of business leaders in southern Ontario who participate in the Bank’s quarterly business outlook surveys. Worst recession since the depression I probably don’t need to tell anyone in this room that the recent global recession was the worst downturn experienced since the Great Depression. In very short order, global GDP fell more than 3 per cent and millions upon millions of jobs were lost. In Canada, 432,000 jobs were lost and GDP fell 4.2 per cent. The unemployment rate spiked to 8.7 per cent. The severity of the global economic and financial crisis delivered a direct, sharp blow to Canadian business. Canada experienced a particularly deep contraction of investment and exports. The trauma was severe and long-lasting. Its impact was felt by businesses across the country, businesses that saw their markets dwindle and their balance sheets deteriorate. In a downturn that lasts, say, nine months, a bank will likely let its clients ride out the recession. But in a prolonged crisis, the story is more complex. Credit can become tough to find. Anecdotally, we know that otherwise solvent and creditworthy firms were left with considerably less credit than they needed. In too many cases, temporary plant shutdowns were not sufficient to match the fall in demand or the decline in financing. Some firms reduced their operations. Others simply closed their doors. Let’s look at some of the facts. During a normal growth period in Canada, there is a steady increase in the number of businesses in operation. In short, creative destruction results in the net creation of new firms. But since the onset of the recession, there has been limited net creation of businesses. Canada’s exporters have been particularly hard hit. The group most profoundly affected has been manufacturing exporters, whose ranks have continued to shrink. Canada is not alone in this regard. In the United States, the dynamics were similar but even more dramatic. The net number of new establishments fell for three years in a row until 2011, when, finally, the trend turned around. BIS central bankers’ speeches The reconstruction challenge Perhaps there should be no surprise, then, given the decline in global demand, the drop in the number of American companies to trade with, and the related drop in the number of Canadian exporters, that Canada’s export sector has lagged. It is the only component of Canada’s GDP that remains below its pre-recession peak. Our annual exports are more than $100 billion lower than would be typical at this point in a recovery cycle. Regaining the lost output of companies that have disappeared or downsized will require that existing firms boost their production, that they invest to expand their capacity, and that the net creation of new firms resumes a higher growth path. The good news is that the balance sheets of corporate Canada are healthy and the capacity to invest exists. We could see that the recession was causing a significant structural change in the Canadian economy at the time. The Bank acknowledged that this destruction of potential was happening in its quarterly Monetary Policy Report in April 2009. Reflecting its best judgment, the Bank reduced its estimates of potential output growth in each of the years from 2009 to 2011. Nonetheless, we were relatively fortunate in Canada. In the immediate aftermath of the crisis, stimulative monetary and fiscal policies proved highly effective in maintaining domestic demand, particularly household expenditures. Household spending was supported by strong growth in borrowing, which resulted in record-high debt-to-income levels. Given the circumstances, it was a good thing that households had the capacity to expand their spending – this provided a necessary cushion from the worst effects of the global contraction. The Bank has been careful to remind people that interest rates will rise at some point. We have urged homeowners and other borrowers to do the arithmetic to ensure that they will be able to manage their debts at more normal interest rates. I am confident that this is exactly what people are doing. This growth model has been effective, but its limits are clear. In fact, while recent data are choppy, we continue to see a constructive evolution of activity in the housing sector. What needs to happen next is for export momentum to build and business investment to recover while the household sector settles into a more balanced and sustainable growth path. For all of this to happen will require the rebuilding of Canada’s economic potential. That is what makes this recovery cycle unique. Automotive sector Let me use some cases studies to illustrate this. The structural transformation of the auto sector has been dramatic. The 70-per cent decline in production from peak to trough was brutal. Machinery was boxed up and sent overseas. Plants closed. These were very hard times for this sector and those who make their living from it. The crisis in the auto sector prompted the federal government to step in with extraordinary financial support. That support helped save thousands of jobs throughout southern Ontario. The firms that survived have lowered their cost structures. We are seeing more innovative processes and accelerated new product development. These elements improve the competitiveness of Canadian firms and position them well to go head-to-head with U.S. and global parts-sector firms. They also help Canada to gain a foothold in global supply chains. The recovery of auto sales in the United States is clearly under way – the first essential ingredient. But it remains to be seen how the reconstruction process I’ve discussed today will play out for this important sector. BIS central bankers’ speeches Forestry I could tell a similar story about Canada’s forestry sector, which – like the auto sector – is much smaller than before. In 2012, the Canadian forestry industry accounted for about 1.2 per cent of total GDP, down from around 1.6 per cent in 2007. During the same period, almost 60,000 workers – about 20 per cent of the forestry workforce – were displaced. Here, too, the recovery in U.S. housing and the building of new relationships in fast-growing markets, such as China, are contributing to improved confidence. I could describe similar stories for other sectors including ICT (information and communications technology) and biotechnology. These are all stories that we need to keep watching. What businesses are telling us From the frequent conversations the Bank has with business leaders, we know that the entrepreneurial spirit is alive and well in Canada. Some of the decline in exports reflects the ingenuity of Canadian firms, including firms in this region, in responding to the U.S. slowdown by pivoting their products and marketing to the faster-growing segments of the Canadian economy. Others became more competitive through restructuring or finding a niche adjacent to their traditional market. Such insights feed importantly into the Bank’s understanding of the workings of the Canadian economy, and thus into the policy deliberations of the Bank – and I strongly believe that, especially in these unusual times, as we work to understand the undercurrents of the recovery, this kind of dialogue with the private sector is critical. Confidence To realize the economic growth that Canada is looking for – a return to self-sustaining, selfgenerating growth – we need to see the rebuilding of capacity, through both the expansion of existing companies and the creation of new ones. This will require growing confidence among existing businesses and entrepreneurs. The gathering momentum in foreign demand, especially in the United States, should help lift the confidence of Canada’s exporters. This is critical for Canadian firms to boost their investment to expand their productive capacity. The sequence we can anticipate is the following: foreign demand will build; our exports will strengthen further; confidence will improve; existing companies will expand; companies will invest to increase capacity; and new ones will be created. This sequence may already be underway. Conclusion To conclude: In monetary policy, actions are critically important. The Bank is absolutely committed, as I mentioned earlier, to keeping inflation predictable, stable and on target so firms can make longer-term decisions in an environment of confidence. But words, too, matter a great deal. By explaining the cross-currents at work in our economy, our projections for what’s ahead, and our monetary policy response, we can help to heal business confidence. And in order to expand our understanding of what’s happening in the real economy, we listen to businesses, to labour groups and to industry associations. Beneath our economic and financial statistics and analysis are real people, making real decisions. Those decisions are hard to make at any time, but when uncertainty is high and confidence low, they can be even more difficult. I am optimistic that the signs are there that the process is under way. Right now, what we need most is stability and patience. BIS central bankers’ speeches To help nurture confidence, an active engagement with Canadians must remain a cornerstone of the policy of the Bank of Canada. So thank you for being here today. I’m keen to hear your views, and I would be pleased to take your questions. BIS central bankers’ speeches
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Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the CFA Society Toronto, Toronto, Ontario, 26 June 2013.
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Timothy Lane: Shedding light on shadow banking Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the CFA Society Toronto, Toronto, Ontario, 26 June 2013. * * * Introduction Thank you for inviting me to speak to you today. I would like to take this opportunity to talk about shadow banking, which is an important area for financial system reform, both globally and in Canada. Shadow banking refers to a set of activities outside the formal banking system that carry out similar functions to those performed by banks. While the term “shadow banking” tends to suggest something secretive or illicit, I will argue that, on the whole, shadow banking serves a useful purpose. At the same time, the experience during the global financial crisis revealed that shadow banking has some important fragilities. I will talk about certain common threads in the reforms being developed at the international level to address these fragilities and their relevance to Canada. How does shadow banking work? Shadow banking comprises activities involving some element of maturity and liquidity transformation, credit extension, and risk transfer, conducted partly or wholly outside the “traditional” banking system. It covers a wide range of activities, including securitization, repos, and money market funds (MMFS) as well as some activities of non-bank financial institutions such as finance companies and credit hedge funds. Different investors have different time horizons and different degrees of tolerance for illiquidity and risk. Investors seeking safe places to park their cash holdings typically prefer to hold assets that are of short maturity and liquid. The economy benefits from the existence of safe assets – assets that can be accepted without constantly having to scrutinize the issuer’s financial statements.1 At the same time, many of the productive long-term investments in the economy – investments that are essential to build its productive potential – are inherently illiquid, long-term, and risky. As a result, there is a clear role for institutions – either banks or shadow banks – to issue liabilities that are shorter-term, liquid and safe while holding longer-maturity, less liquid and/or risky assets. At the same time, this role brings with it intrinsic risks, as seen by bank runs and failures throughout the history of banking. Such risks are also illustrated by the implosion of some shadow banking activities – such as the collapse of asset-backed commercial paper and runs on repos and MMFs – during the global financial crisis. So how do you establish confidence that liabilities are safe and liquid? Banks have a number of features that help them establish confidence. Traditionally, they seek to build and maintain reputations for safety and soundness, in part to earn profits based on those reputations. They typically engage in a broad range of activities, both to diversify their risks and to pursue such profit opportunities. The scope of their activities in many cases makes banks highly interconnected with the rest of the financial system. A paper by G. Gorton, S. Lewellen, and A. Metrick, “The Safe-Asset Share,” American Economic Review 102 (3)(2012): 101–106, discusses the economic role of safe assets – characterized as assets that are “informationally insensitive” – and shows that they have been stable as a share of total assets over a long historical period. BIS central bankers’ speeches Banks also maintain confidence through their capital and liability structure. The capital invested by their shareholders is available to absorb losses. They hold liquid assets so that they can redeem deposits on demand. At the same time, since banks are highly leveraged, they have a strong incentive to manage the risks to which they are exposed, notably credit risk, including by collecting information about their borrowers and monitoring their behaviour. Strong banks have long been synonymous with high capitalization levels, conservative balance-sheet structures, and robust risk-management and lending standards. Despite these traditional features, banks are still subject to runs and failures, which carry enormous costs for the economy. From the Great Depression to the Great Recession, instances of banking failures have led to public policy initiatives to make banks safer. Central banks provide liquidity to banks that are solvent but have run short of liquid assets. Deposit insurance reduces the incentive for depositors to run on a bank in times of stress. These elements of the “safety net” are complemented by stringent regulation – requiring that banks have enough capital to absorb losses and enough liquid assets to meet plausible potential drains. In addition, bank supervisors scrutinize many aspects of their operations. Regulation and supervision are essential to maintain depositor confidence and to ensure that banks do not rely excessively on the safety net – thus limiting moral hazard. So what about shadow banking? Confidence in shadow banking is partly based on collateral. For example, investors hold asset-backed securities mainly on the strength of the underlying assets, rather than on the reputation of the issuer – which may be an anonymous special purpose vehicle created for the sole purpose of holding the assets and issuing securities. Similarly, investors provide cash in repo transactions because, even if the institution receiving the cash were to default, the institution providing the cash would have a claim on the underlying asset. In other cases, shadow banking assets are perceived to be safe because of the narrow range of activities in which they engage. For example, MMFs provide a close substitute for bank deposits, partly because they invest only in very liquid, short-term, low-risk securities. Other shadow banking institutions, such as credit hedge funds and finance companies, have structured their assets and liabilities in various ways to avoid being subject to runs. Thus, shadow banks have a variety of business models to maintain investors’ confidence and obtain access to financing. These models are different from those of regular banks, and from one another. So what is the advantage of shadow banking, given that banks already exist? For some forms of intermediation, shadow banking may be more efficient and provide healthy competition for traditional banks. Room on banks’ balance sheets is expensive, so avoiding the use of those balance sheets can save money and free up lending capacity. The regulations to which banks are subject may also give them less flexibility to serve some sectors of the market, or at least restrict their ability to offer those customers a competitive package. Where banks do not tread, shadow banking steps in to fill the gaps and make the financial system more efficient. A financial system with a diverse set of business models may be both more innovative and more resilient. And, given that banks are often highly interconnected, there may be an advantage, in the interest of financial stability, to transferring some risk outside of the banking system. In particular, by using market mechanisms to distribute and diversify this risk, it will end up being borne by those investors most willing to hold the risk. At the same time, shadow banking can be a form of regulatory arbitrage, circumventing the regulations to which banks are subject. Such behaviour can create distortions and additional risks to the system. As bank regulations are tightened, the incentives for such behaviour obviously increase. BIS central bankers’ speeches While banks and shadow banks have separate functions and activities, it is important to remember that their paths intersect. Shadow banking relies on traditional banks. Many forms of shadow banking, such as asset-backed commercial paper and related structured products, often require support from banks through liquidity lines to bring them to market. And banks in turn rely on shadow banking for funding, for example, through repo residential mortgage backed securities or covered bonds. What went wrong? The weaknesses of both traditional banking and shadow banking were clearly exposed during the global financial crisis: both proved vulnerable to run-like behaviour despite features intended to bolster confidence. A number of core funding markets froze up as financial institutions lost the confidence to lend to one another. The flight from counterparty risk reflected the vulnerabilities of many banks, as well as the fragility of the shadow banking system. I won’t dwell on the vulnerabilities of the banks and how they are being addressed, since that has been discussed in considerable detail elsewhere, but I will discuss some of the weaknesses exposed in global shadow banking. During the crisis, repo markets came under severe stress. Market makers and cash lenders became less able and willing to provide repo financing, and, as a result, some repo borrowers experienced difficulties financing even good-quality collateral. Borrowing limits were reduced, the terms of transactions shortened, haircuts on private securities accepted as collateral widened and the range of securities accepted as collateral narrowed down to all but the safest. The volume of repo transactions dropped off sharply. Such strains were experienced in Canada and around the world. Markets for various asset-backed securities collapsed. In the United States, markets for mortgage-backed securities and various other structured products essentially closed: issuance stopped, prices fell sharply, and perceptions of these securities’ safety were badly damaged. Canada experienced its own crisis in non-bank asset-backed commercial paper in mid-2007; only coordinated action by the public and private sectors prevented potentially catastrophic system-wide repercussions. Money market funds in the United States experienced substantial drains, as fears emerged that these funds would have to “break the buck.” The Federal Reserve introduced extraordinary liquidity facilities and the United States government provided temporary guarantees to halt a full-fledged run. These developments were similar to traditional bank runs – a general withdrawal of participation from certain markets for fear of counterparty risk. They also exposed the risks associated with the use of collateral as it became more difficult to value and dispose of in illiquid markets. We saw that as the system came under stress, market participants faced the prospect of unloading collateral at fire-sale prices – in many cases exposing institutions to “wrong-way” risks for which they were inadequately prepared.2 For similar reasons, margins on derivatives transactions and haircuts on collateral increased. These stresses in the shadow banking system amplified the stresses on the financial system more generally and transmitted them globally. Another underlying issue that surfaced was the misalignment of incentives. Here, a striking example is the case of mortgage-backed securities, structured products and the “originate to distribute” model. Since investors could not readily assess the quality of the assets backing “Wrong-way” risk refers to the risk that the value of collateral is more likely to decline under the same circumstances in which a counterparty is more likely to default. (In other words, collateral turns out to be insufficient precisely when it is needed most). BIS central bankers’ speeches these securities, there was an incentive for originators to use, and over-issue, lower-quality assets, knowing that they would earn the origination fees, while the investors would bear the risk. Moreover, the complexity of some structured products obscured high levels of leverage, which exacerbated losses when the underlying asset values declined.3 The linkages between traditional banks and shadow banks meant that vulnerabilities spread. For example, when asset-backed securities came under pressure, the sponsoring banks faced significant drains through the credit and liquidity lines they had provided. In some cases, they ended up standing behind the asset-backed securities they had sponsored, largely to maintain their reputations, despite having no legal obligation to do so. At the same time, since shadow banking had become an important source of funding for the banks themselves, stresses in shadow banking had an impact on the banks: for example, when repo markets seized up, banks faced severe funding pressures. How to fix it? The experience of the crisis points to a need for reforms that will enable shadow banking to continue to play a useful role while addressing its inherent risks. The purpose here is not to stamp out all risk, but to ensure that risks are appropriately understood and managed. A related purpose is to prevent an increase in shadow banking activity driven solely by regulatory arbitrage in response to the tightening of regulations faced by banks. The Financial Stability Board (FSB) has mapped out international work on shadow banking, identifying five work streams: links between banks and shadow banking; money market funds; other shadow banking organizations; securitization; and securities lending and repos. The FSB has also begun monitoring the evolution of the sector and the associated risks. To guide the key reforms, the FSB has established some basic principles. The regulatory measures should be: • focused, to target the risks that shadow banking creates; • proportionate to the risks to the financial system; • forward looking and adaptable to emerging risks and innovations; • effective, so that they balance the need for international consistency as well as jurisdictional differences; and, finally, • regularly assessed and reviewed following implementation, and improved as necessary. I would like to stress some common threads that run through the global reform agenda: reducing susceptibility to runs and liquidity freezes and better aligning incentives. Let me talk about how they apply to three shadow banking activities: repo markets, securitization and MMFs. With repo markets, a key element is to reduce vulnerability to the kind of concerns about counterparty risk that surfaced during the crisis. One important aspect of the reform discussion relates to how market participants set haircuts – the amount of collateral they require – on repo transactions. The focus on haircuts is a question of perception versus In the United States, during the pre-crisis period, securitization did not disperse risks to the extent that had been believed. In fact, it amplified the exposure of many institutions to a common shock linked to the U.S. housing and mortgage markets and may have increased interconnectedness within the financial system. The widespread use of credit ratings for these structured mortgage products gave investors a misleading sense of security because these ratings were primarily based on the idiosyncratic risks of the mortgages in the securitization pool, rather than on the systemic risk of a collapse in the U.S. housing market. The Financial Stability Board has since introduced principles to reduce reliance on ratings from credit-rating agencies. BIS central bankers’ speeches reality. It recognizes that when market conditions are good, with low volatility and low perceived levels of risk, the haircuts charged by market participants can fall below levels that might be considered prudent from a risk-management perspective. This can result from competitive pressures among financial institutions or because haircut methodologies place more weight on recent benign market movements. Declines in haircut levels increase the ability of market participants to obtain leverage, which in turn can fuel further increases in asset prices. When a shock hits, this cycle can quickly reverse as asset prices fall, volatility spikes, haircuts are raised and margin calls ensue.4 In light of this possibility, serious consideration is being given to enforcing minimum quality standards for the methodologies that market participants use to set collateral haircuts for repos. This could include imposing minimum numerical haircuts for certain types of more risky transactions.5 Now let me turn to securitization. Here, one of the priorities is to align the incentives of institutions that originate loans with those of investors. Proposals have focused on the need to ensure that the originators have “skin in the game,” by requiring them to retain a certain minimum share of the securities they sell, and to enhance transparency regarding the underlying assets. Proposals for the reform of MMFs focus on reducing their vulnerability to run-like behaviour. Like bank deposits, an MMF traditionally promises to redeem its shares at par, that is, at a constant net asset value. The MMF investors may thus have an incentive to run in a case where the assets may be insufficient to back up that claim – for instance, if there are concerns that the fund may have suffered serious credit losses on some assets. Various proposals to address that weakness are on the table: moving to variable net asset value; requiring a cushion of capital or imposing tighter requirements on the liquidity of the assets held by the MMF; establishing “gates” – i.e., restrictions on investors’ ability to withdraw their money at short notice; or a combination of these measures. The goal is to make MMFs less vulnerable to runs without ending their usefulness as a close substitute for bank deposits and an important source of short-term funding for a number of private and public sector borrowers. What does this mean for Canada? So far, I’ve been talking about shadow banking issues mainly from an international perspective. Now I would like to focus on how these issues apply here at home. In Canada, shadow banking is more limited in scale and scope than in other jurisdictions, especially the United States, where competitive pressures and regulatory restrictions drove some activities out of the banking system. Let’s look at some numbers. Shadow banking in Canada represents about 40 per cent of activity in the traditional banking sector, down from an average of about 50 per cent during the decade before 2008. As a share of GDP, Canadian shadow banking is roughly 40 per cent, compared with about 95 per cent in the United States.6 Committee on the Global Financial System, 2010, “The Role of Margin Requirements and Haircuts in Procyclicality,” CGFS Publications No. 36. Financial Stability Board, 2012, “Securities Lending and Repos: Market Overview and Financial Stability Issues,” Interim Report of the FSB Workstream on Securities Lending and Repos, 27 April. See, T. Gravelle, T. Grieder and S. Lavoie, “Monitoring and Assessing Risks in Canada’s Shadow Banking Sector,” Bank of Canada Financial System Review (June 2013): 55–63.This is a measure of shadow banking activities, some of which are undertaken by banks and other regulated financial institutions. This is in contrast to entity-based measures reported by the FSB, which comprise only the assets of institutions outside the perimeter of prudential regulation. According to the FSB definition, assets of shadow banking entities in BIS central bankers’ speeches The composition of shadow banking is also different in Canada than elsewhere. One key element is repo markets, which are an important funding market for Canadian financial institutions. Although repo markets are based primarily on government securities involving little credit risk, and in most cases at least one of the counterparties is a regulated financial institution, during the crisis they experienced the kind of freezes that occurred in other countries. This experience is motivating the move toward central clearing of repos using the Canadian Derivatives Clearing Service, which went live last year.7 A very important element of shadow banking in Canada is the securitization of governmentguaranteed mortgages, which essentially converts illiquid assets – mortgages – into more liquid, securitized debt instruments. This form of securitization has more than doubled over the past five years.8 When mortgage lending is funded by issuing debt securities backed by insured mortgages, it moves mortgage lending away from its traditional on-balance-sheet model whereby mortgages are funded by branch-sourced, retail deposits. This represents a relatively low-cost form of term funding for financial institutions. Here, a key concern is the potential misallocation of resources away from non-mortgage lending toward mortgage credit – which, in the current economic environment, contributes to the buildup of imbalances in the household sector.9 Another aspect of the securitization of insured mortgages is the increasing role of specialized mortgage-lending institutions. These institutions are not subject to the same level of scrutiny as banks and in some instances don’t have access to as stable and diversified sources of funding. While their small size suggests that they do not pose systemic risk, they do involve elements of shadow banking risk that call for careful monitoring. Money-market funds make up a fairly small segment of shadow banking in Canada. At the end of 2012, Canadian MMFs had approximately $30 billion of assets under management, less than half of the peak level reached in 2009. Despite their small size, the risk of runs posed by MMFs still exists and must be managed carefully. Coming in from the shadows Recognizing both the benefits and the risks of the shadow banking sector, we need to continue working to make it safer. Internationally, we are working with our partners in the FSB to develop an integrated set of recommendations that will be presented at the G-20 meetings in St. Petersburg in September. The Canadian authorities will need to decide how to implement the reforms that are agreed at the global level. Some measures that could be considered include: • Establishing consistent standards for how haircuts are set on repo transactions, including numerical minimum haircuts for some types of transactions; • Requiring that originating securitized products have enough skin in the game to align their incentives better with those of investors; Canada were 28 percent of GDP in 2011. The measure of traditional bank liabilities consists of gross deposits (including longer-term Canadian-dollar unsecured debt), subordinated debt and the foreign currency deposits of Canadian residents. A. Côté. 2013. “Toward a Stronger Financial Market Infrastructure for Canada: Taking Stock.” (speech to the Association for Financial Professionals of Canada (Montréal Chapter), Montréal, Quebec, 26 March). The value of securitized mortgages grew from $160 billion in 2007 to $386 billion at end-2012. The Bank of Canada’s June 2013 Financial System Review provides an updated assessment of the systemwide risks associated with household sector imbalances. BIS central bankers’ speeches • Making money market funds less vulnerable to runs, through an appropriate combination of capital and liquidity requirements, and restrictions on withdrawals; • Establishing a clear and consistent framework for regulating other shadow banking institutions; • Limiting banks’ exposure to shadow banking activity; and • Providing the right degree of transparency around many aspects of shadow banking, so that market discipline can work better. Conclusion As I have stressed, shadow banking delivers important benefits to the economy. There is a need for the liquidity and maturity transformation, credit extension and risk transfer it provides. In delivering these services, it is healthy to have an alternative to the traditional banking system that provides competition, diversity and innovation. At the same time, reforms are needed to make shadow banking safer. Shadow banking should be made less susceptible to run-like behaviour and contagion. Aligning incentives – through transparency and appropriate regulation – is also essential. Canada has a stake in these reforms, both as a beneficiary of a more resilient global financial system and because our own shadow banking activities could be made more robust. Since innovation is one of the key benefits of shadow banking, innovation is also a fact of life in regulating the sector. Shadow banking has been known to reinvent itself and will continue to do so in response to regulation. We will need to develop and adopt principles that are broad-based enough to encompass new activities. Risk is inherent in the global financial system. We can’t stamp it all out, nor would we want to. Rather, the goal is to create incentives so that risk is allocated and managed appropriately, both in banking and in shadow banking activities, making the entire financial system stronger and more resilient. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 17 July 2013.
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Stephen S Poloz: Summary of the latest Monetary Policy Report Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 17 July 2013. * * * 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. • Global economic growth remains modest, although the pace of economic activity varies significantly across the major economies. • The U.S. economic expansion is proceeding at a moderate pace. The continued strengthening in private demand is being partly offset by the impact of fiscal consolidation. • In Japan, fiscal and monetary policy stimulus is contributing to a rapid recovery in economic growth. • In contrast, economic activity in the euro area remains weak. • In China and other emerging market economies, real GDP growth has slowed, although it is stronger than in the advanced economies. This is exerting downward pressure on global commodity prices. • And, as a consequence, the Bank has downgraded slightly its global growth forecast. • The global economy is still expected to pick up in 2014 and 2015. • In Canada, economic growth is expected to be choppy in the near term, owing to unusual temporary factors. The overall outlook is little changed from the Bank’s projection in April. • Annual GDP growth is projected to average 1.8 per cent in 2013 and 2.7 per cent in both 2014 and 2015, supported by very accommodative financial conditions. • Despite ongoing competitiveness challenges, exports are projected to gather momentum. This should boost confidence and lead to increasingly solid growth in business investment. The economy will also be supported by continued growth in consumer spending, while further modest declines in residential investment are expected. • Growth in real GDP is projected to be sufficient to absorb the current material excess capacity in the economy, closing the output gap around mid-2015, as projected in April. • Inflation has been low in recent months and is expected to remain subdued in the near term. • The weakness in core inflation reflects persistent material excess capacity, heightened competitive pressures on retailers, relatively subdued wage increases, and some temporary sector-specific factors. Total CPI inflation has also been restrained by declining mortgage interest costs. • As the economy gradually returns to full capacity and with inflation expectations well-anchored, both core and total CPI inflation are expected to return to 2 per cent around mid-2015. BIS central bankers’ speeches • The outlook balances the many upside and downside risks to inflation. Three of the most important emanate from the external environment, and include the risks of stronger U.S. private demand, a failure to contain the crisis in Europe, and weaker growth in China and other emerging-market economies. • The most important domestic source of risk to the Canadian economy remains the possibility of a disorderly unwinding of household sector imbalances. • Against this backdrop, the Bank today decided to maintain the target for the overnight rate at 1 per cent. • As long as there is significant slack in the Canadian economy, the inflation outlook remains muted, and imbalances in the household sector continue to evolve constructively, the considerable monetary policy stimulus currently in place will remain appropriate. Over time, as the normalization of these conditions unfolds, a gradual normalization of policy interest rates can also be expected, consistent with achieving the 2 per cent inflation target. With that, Tiff and I would be pleased to take your questions. BIS central bankers’ speeches
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Canadian Association for Business Economics, Kingston, Ontario, 27 August 2013.
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John Murray: Exits, spillovers and monetary policy independence Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Canadian Association for Business Economics, Kingston, Ontario, 27 August 2013. * * * Introduction Extraordinary monetary policy measures were taken in the heat of the financial crisis, and continue to be applied five years later, as a necessary part of restoring economic growth and stability. While no major advanced economy currently employing these measures is expected to begin withdrawing monetary stimulus in the near future, mildly encouraging data from the United States, coupled with recent statements from various Federal Reserve officials, have definitely caught the market’s attention. The outsized impact that the statements had on asset prices around the world is notable for a number of reasons. First, the statements only suggested that, provided economic data continued to come in largely as expected, the Fed might start reducing the rate at which further monetary stimulus was being added to the system. This is materially different from actually reducing the amount of stimulus which, in the case of the United States, is still expected by most observers to begin in the second half of 2015. Second, market consensus, as judged by commentary just prior to the Fed statements, had already arrived at the same conclusion – specifically, if economic events transpired as projected, Fed “tapering” would begin sometime in the autumn or early winter of 2013. In other words, the Fed’s statements were merely confirming, in a conditional sense (i.e., with no guarantees), what the market already expected. Despite all of this, the pronouncements appeared to trigger an exaggerated reaction in financial markets. Bond yields spiked, and prices for a number of other financial assets that had benefited from expectations of ongoing asset purchases by the Fed dropped precipitously, not just in the United States but in almost every other country. The magnitude of the response was viewed by many with a mixture of surprise and alarm. Surprise because these prospective policy moves had been so widely anticipated and clearly telegraphed by the Fed, and because the market reaction was so pervasive. Alarm because it suddenly seemed that unwinding unconventional monetary policies (UMP) might not be as straightforward and painless as many had thought or at least had hoped. The fears voiced by UMP critics appeared to have been confirmed. My objective here today is twofold: first, to put these developments in a broader context and diffuse some of the angst that has surrounded them; second, to view them more specifically from the standpoint of Canada. What are the likely implications for our economy? What are the possible risks? What are the elements that, especially from a Canadian perspective, provide some comfort? Uncharted waters Policy-makers around the world responded in a timely and aggressive manner in the autumn of 2008, when what had previously been characterized as a period of “extreme market turbulence” developed into a full-blown crisis. The severity of the situation was quickly recognized, as was the potential for it to degenerate into another Great Depression, but on a truly global scale. Coordinated and substantive fiscal remedies were applied, together with concerted monetary policy easing. However, room for manoeuvre on the fiscal front in most advanced economies (AEs) was soon exhausted, and attention had to turn to fiscal consolidation as opposed to expansion. Monetary policy was, by default, the “only game in town” – but it, too, faced a critical constraint. BIS central bankers’ speeches Low inflation and the impossibility of pushing nominal interest rates significantly below zero meant that there was little scope for lowering real interest rates and easing credit conditions by conventional means. Official short-term interest rates – the instrument of choice for central banks – were cut aggressively but soon hit the zero lower bound, where most of them have remained for the past five years (Chart 1). This in itself was an “unconventional” development. Official short-term rates had never been as low or had remained there for as long. It was soon apparent, however, that even this would not provide sufficient easing to restore market functioning and resurrect collapsing economic activity. Other, more unconventional, means would have to be deployed. These alternative measures took two forms. The first is often referred to as “forward guidance,” and involves an explicit commitment by central banks to leave short-term interest rates low for a prolonged period. By doing this, central banks hope to condition market expectations, lowering interest rates further out the yield curve (much like additional cuts to short-term interest rates would have done, had they been possible). The commitment to extend monetary easing well beyond the point where central banks might have been expected to begin tightening under more normal circumstances also served to raise inflation expectations, thereby lowering the real rate of interest even further. The increased certainty provided by forward guidance regarding the path of future rates reinforced this stimulative effect.1 Most central banks that used this instrument initially relied on a loose form of calendar or date-based guidance, in which they committed to leave rates low for “an extended period of time.” In some cases, a more specific time frame was mentioned, such as mid-2014 or mid2015. The commitment was not unconditional, however. There was a clear, if implicit, understanding that, if the state of the macroeconomy and the inflation outlook were to change materially, the central bank would respond appropriately. The Bank of Canada pioneered the use of conditional guidance in April 2009.2 It committed to hold the policy rate at its effective lower bound through the second quarter of 2010, conditional on the outlook for inflation. The Bank’s guidance succeeded in changing market expectations regarding the future path of interest rates, providing the desired stimulus and thereby underpinning a rebound in growth and inflation in Canada (Chart 2).3 In more recent applications, forward guidance has become more explicitly outcome- or databased, with some central banks identifying thresholds such as specific rates of inflation or unemployment which, if crossed, would prompt a reconsideration of their policy track. The second form of unconventional monetary policy employed by many central banks involves purchasing large amounts of government bonds or other financial instruments. “Quantitative easing,” as it is generally known, is viewed as a complementary and more direct means of easing credit conditions, exerting immediate upward pressure on the prices of the assets that were purchased, as well as those of other assets, through a process of At the zero lower bound, interest rate risk is asymmetric: short-term rates can rise, but they cannot fall. This asymmetry causes the mean or expected outlook for short rates to be greater than the modal or most likely path. Thus, guidance can lower long-term rates by reducing uncertainty about the future path of short-term rates, even if it does not change the modal expectation as to the duration at the lower bound. For a review of the evolution of forward guidance, see M. Carney, “Monetary Policy After the Fall” (Eric J. Hanson Memorial Lecture, University of Alberta, Edmonton, 1 May 2013). See Z. He, “Evaluating the Effect of the Bank of Canada’s Conditional Commitment Policy,” Discussion Paper No. 2010–11, Bank of Canada, 2010; and M. Woodford, “Methods of Policy Accommodation at the InterestRate Lower Bound,” paper presented at the Jackson Hole Symposium, “The Changing Policy Landscape,” 31 August–1 September 2012 BIS central bankers’ speeches portfolio substitution.4 It is this form of unconventional monetary policy that has probably provoked the greatest degree of unease on the part of many market participants. Chart 3 shows how the balance sheets of various central banks have grown over the past five years. They have now reached levels equivalent to 20 or 30 per cent of GDP. In the case of Japan, the central bank’s balance sheet is projected to hit nearly 60 per cent of GDP within the next two years. While a number of vocal critics dispute the wisdom of these actions, there is general agreement – based on a growing body of evidence – that forward guidance and quantitative easing have had a significant and beneficial impact. Credit conditions have improved, market functioning has been restored and interest rates well out the yield curve have been lowered materially. More importantly, real economic activity and employment have been supported, and a global deflation/depression has been avoided.5 Some people believe that these policies will prove too effective and will induce runaway inflation; others believe that they have been largely ineffective but carry significant future costs in the form of financial instability and lost central bank independence. Even the supporters of unconventional monetary policies would acknowledge that they involve some risk, but that, at least until now, the benefits have far outweighed any current or prospective costs. Extricating ourselves from UMP and effecting a smooth exit, the critics argue, is going to be extremely difficult if not impossible. They contend that the situation is “unprecedented,” and that we are in “uncharted waters.” Once bitten... One can understand why emerging-market and developing economies (EMDEs) might feel particularly exposed. Over the postwar period, there have been repeated episodes of sharp interest rate increases in the advanced countries followed by financial crises in EMDEs. In the post-Volcker period, for example, short-term interest rates in the United States have jumped by more than two percentage points within a one-year period on several occasions. A similar, although slightly less extreme, pattern can be observed in long-term interest rates. One of the best-known examples of a disorderly jump in U.S. long-term rates occurred in 1994, immediately preceding the Mexican financial crisis (Chart 4). Mexico’s experience is not unusual. In many cases, the spillover effects on EMDEs have been dramatic. Moreover, these episodes involved large adjustments in conventional, as opposed to unconventional, monetary policy. Aggressive tightening in the early 1980s by Quantitative easing refers to outright purchases of financial assets funded by the expansion of the monetary base through the creation of central bank reserves – in other words, enlarging the central bank’s balance sheet. If assets are imperfect substitutes, these purchases push up the price of, and reduce the yield on, the purchased assets (which are normally government securities but could include private assets). As private investors rebalance their portfolios toward other assets, the stimulative impact is spread across financial markets. Many central banks, especially during the most acute phases of the crisis, also employed policies known as “credit easing,” which involves purchases of private sector assets in certain credit markets that are important to the functioning of the financial system but are temporarily impaired. The objective of credit easing is to reduce risk premiums and improve liquidity and trading activity in these markets. In addition to these “hydraulic” effects, both quantitative and credit easing can have “signalling” effects. That is, both can affect perceptions of the central bank’s reaction function. Like forward guidance, signalling effects can provide additional stimulus by affecting expectations of future monetary and financial conditions. See E. Santor and L. Suchanek, “Unconventional Monetary Policies: Evolving Practices, Their Effects and Potential Costs,” Bank of Canada Review (Spring 2013): 1–15; B. Bernanke, “Monetary Policy Since the Onset of the Crisis” (speech at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, 31 August 2012); and M. Joyce, M. Tong and R. Woods, “The United Kingdom's Quantitative Easing Policy: Design, Operation and Impact,” Bank of England Quarterly Bulletin (2011Q3): 200?212. BIS central bankers’ speeches Volcker, for example, coincided with the beginning of the Latin American debt crisis and the so-called “lost decade.” This is not to say that policy tightening by advanced economies was always the primary cause of these crises, nor was it always the catalyst. Many, if not most, were self-induced. Ironically, concern among EMDEs over the past five years has focused mainly on the problems associated with too much monetary easing in advanced economies. Negative spillover effects in the form of excessive capital inflows and upward pressure on their exchange rates have at times made it difficult for them to control domestic credit conditions and have threatened their international competitiveness. Without arguing the merits of these complaints in detail, it is perhaps worth noting the following. First, most observers, including the International Monetary Fund, believe that pull factors have been more important than push factors in attracting these capital inflows. In other words, the inherent attractiveness of investing in EMDEs, as opposed to accommodative policies elsewhere, was the major driving force. Second, the argument overlooks the fact that UMP presumably led to faster growth in the advanced economies and the global economy more generally, which benefited the EMDEs. The alternative would have been much less appealing. Finally, there might have been less need for UMP were it not for the restrictive measures that many of the EMDEs had used to control capital flows and exchange rate movements beginning well before the crisis. These restrictive measures contributed to sizable global imbalances, which in turn fuelled the crisis. They also inhibited the required rebalancing of global demand after the crisis, increasing the need for aggressive monetary policy responses by the United States and other advanced economies. Spillover effects from policies run both ways. EMDEs have grown large enough that their collective influence on global conditions now matches that of the advanced economies. Why this time might be different Before getting too excited about the negative consequences of exiting, it is important to step back and consider why events might unfold in a manner that is more benign than some critics have feared. The first – and most obvious – reason is that the exit will start from a point of extraordinary policy accommodation, and will involve gradually reducing the amount of stimulus in place, as opposed to initiating a rapid and severe policy tightening. Moreover, it will be undertaken only when officials believe there are clear and convincing signs that the U.S. economy and, subsequently, others, have achieved self-sustaining momentum (“escape velocity”). In this sense, exiting should be regarded as a good and natural thing. Unlike earlier episodes, these actions will not be taken in the context of an overheated economy that requires a quick and substantive dose of policy tightening to dampen economic activity and inflationary pressures. The second reason is that monetary authorities have learned the value of clear communication from previous unfortunate experiences, such as in 1994, when almost no attempt was made to forewarn markets.6 The same can be said of the more positive experience of the past few years in which effective communication has been used successfully to condition market expectations. Federal Reserve Board Chairman Alan Greenspan did try to prepare markets for higher short-term interest rates in testimony before the Joint Economic Committee a few days before the February 1994 meeting of the Federal Open Market Committee at which the tightening began. However, this preparation was quite minimal in comparison with recent Fed statements about “tapering.” BIS central bankers’ speeches The third reason is that not all advanced economies will be exiting from UMP at the same time, because they are at different points in the business cycle. Much of Europe is still in recession and the European Central Bank is considering additional policy easing.7 Japan is in the midst of more ambitious easing as part of the “Three Arrows” program for reflating its economy. The lack of synchronization in policy stances across countries should help to moderate the reaction of global interest rates. The fourth reason is that unconventional monetary policy is not really all that unconventional, either in concept or application. In many ways, it is a throwback to an earlier era. Using asset purchases to inject or withdraw high-powered money into or from the economy is how most textbooks used to describe the monetary policy process. Conducting monetary policy by indirect means, through announced changes in the target overnight rate, while simpler and effective in normal times, is a relatively new development. Guidance, the other form of UMP, is simply a modern version of moral suasion and window guidance, which were actively used by most central banks through the 1950s and 1960s (if not later). The pre-Treasury Accord period also serves as an example of rather direct guidance.8 Neither is the scope nor size of the monetary policy adjustment unprecedented. It all depends on how you measure it. The growth in asset purchases, whether measured in absolute terms or relative to GDP, is truly enormous, and is no doubt responsible for much of the shock and awe that UMP has attracted. However, if one focuses on the resulting growth of credit over the recent period or the movements in long-term interest rates, the effects are less concerning.9 The swings in credit and interest rates from the start of many past tightening episodes to their conclusion were much wider than anything currently contemplated. This is not to say that the process is without risks or will necessarily be smooth. However, as noted earlier, authorities have learned some valuable lessons about communication and the importance of working with markets. Their intentions and tentative game plans have been clearly laid out, as well as the events that would likely trigger the start of the exit. In the United States, for example, the Fed has introduced explicit thresholds and outlined the sequence in which the withdrawal of stimulus would likely proceed. The exit would be preceded by a gradual decrease in the size of asset purchases (i.e., a slowing in the amount of extra easing), followed by the end of asset purchases, a gradual withdrawal of excess liquidity from the system, measured increases in the federal funds rate and, eventually, a normalization of the Fed’s balance sheet. All of this would be contingent on the evolving state of the economy. Importantly, incentives would be well aligned. Those countries that are At the European Central Bank’s July and August press conferences, ECB President Mario Draghi stated that the ECB’s Governing Council was maintaining an easing bias. In August, he said specifically that they had unanimously agreed that “the key ECB interest rates, including the rate on the deposit facility, will remain at present or lower levels for an extended period of time.” He emphasized that this downward bias is due to the subdued outlook for inflation. See http://www.ecb.europa.eu/press/pressconf/2013/html/is130801.en.html. In 1942, after the United States entered the Second World War, the Federal Reserve committed to maintaining a low interest rate peg on government bonds. It did so at the request of the U.S. Treasury. The Fed’s independence was restored in 1951 with the Treasury Accord. The fact that large changes in the monetary base have been associated with only moderate changes in credit and interest rates may lead some to conclude that these policies have been less effective than anticipated. This conclusion, however, is based on a faulty premise. In fact, the magnitude of the change in the monetary base is not surprising. As the opportunity cost of holding money – the nominal interest rate – declines, the interest elasticity of money demand increases. Near the zero lower bound, this effect causes the velocity of money to collapse. The effectively infinite demand for money causes the relationship between the narrow and broad monetary aggregates (the money multiplier) to break down. Consequently, changes in the monetary base have almost no effect on asset prices and aggregate demand. Rather, the stimulative effects of UMP are mainly attributable to the induced changes in the composition of private sector portfolios and signalling effects. BIS central bankers’ speeches exiting would understand the dangers of leaving too early or too late, while those countries that would feel the effects should have no desire to see the process unfold any differently. Having a major advanced economy fail to reach escape velocity through a premature exit, or generate an inflationary spiral through a late departure, would surely be in no one’s long-term interest. Spillovers Spillovers are an unavoidable consequence of openness and globalization. Policy actions by systemically important countries – both AEs and EMDEs – will necessarily have an impact on others. Indeed, similar actions by many small countries, taken together, would have the same effect. Moreover, there should be no presumption that spillovers are always and everywhere bad, although the term admittedly sounds slightly pejorative. Actions taken by one country that are in its own long-term interest (keeping its house in order) typically benefit others (keeping the neighbourhood safe). More fundamentally, the benefits that open markets bring by directing capital to its most productive ends and allowing countries to maximize the gains from trade cannot typically be separated from other external shocks without serious costs. Those countries with less-developed institutions and financial systems, limited policy credibility, greater foreign currency debt and/or more precarious economic situations are certainly more exposed than others to external shocks.10 It is, therefore, not surprising that the recent Fed statements had a larger impact on assets in EMDEs with higher debt and deficits and that are perceived to be more dependent on external financing (Charts 5, 6). This was a natural and predictable reaction, but one that should be largely reversed unless fundamentals justify it. The first response that countries should make if the shocks persist, and are regarded as unhelpful, is to review the stance of their own fiscal and monetary policies to determine whether there is anything that requires adjustment. If the external shocks seemed to pose financial stability risks, macroprudential measures might be introduced as a complement or backstop to existing regulations and oversight of domestic financial systems. However, they should be used judiciously by targeting financial vulnerability itself, and not as a pretext for more protectionist and, ultimately, welfare-eroding measures. The temptation to impose additional capital controls, engage in persistent and large-scale exchange rate intervention and otherwise inhibit necessary adjustments in relative prices should be resisted. Some countries that dislike the spillover effects associated with the monetary policies of AEs are also unhappy with the options that they have for managing them. Many of these countries favour fixed exchange rate arrangements. However, trying to stabilize the exchange rate with monetary policy is viewed as undesirable because of the implications for domestic credit conditions. Capital controls would allow them to stabilize domestic credit conditions and the exchange rate but create serious distortions over time. The preferred solution, in the opinion of many of these countries, is for the United States to internalize the effects of its monetary policies – more specifically, not to exit or at least to do so at a time that is more convenient for others. In previous episodes, an accumulation of foreign currency sovereign debt played an aggravating role. In the current situation, it is firms in EMDEs, not sovereigns, that have built up significant unhedged short-term foreign currency debt. A depreciation of EME currencies would raise the local currency value of firms’ debt. EME authorities could limit the accumulation of foreign currency debt in the future by adopting appropriate regulatory measures and by allowing for greater exchange rate flexibility. The latter would discourage unhedged foreign currency debt by creating two-sided exchange rate risk. BIS central bankers’ speeches The problem that these unhappy countries face has a long history in international economics – old wine in new bottles. The most succinct exposition of this problem is often credited to the Canadian economist Robert Mundell, and is popularly referred to as the “impossible trinity” or “trilemma” (Figure 1).11 Countries, Mundell observed, cannot simultaneously enjoy the advantages of free capital movements, a stable exchange rate and an independent monetary policy. Only two of the three are possible at any one time, so countries must choose. Following the advice of their critics would oblige the United States and several other AEs to surrender some of their monetary policy independence. In our view, however, this would be a Faustian bargain. There is a much better way to proceed. The trilemma should be resolved by allowing exchange rates to float, while preserving the free movement of capital and monetary independence for all. Other palliatives might be appropriate as a temporary expedient if there is obvious evidence of market excesses, but should not be used as an ongoing crutch. Canada’s experience Globalization and the economic interdependence that it implies are nothing new for Canada. We have always been a relatively small and open economy with close ties to other, much larger, economies. Globalization and the emergence of new economic powers in Asia and Latin America have expanded the number of connections but not the fundamental facts of Canada’s economic situation or the policy environment within which we operate. Canada abandoned all of its currency controls and virtually all of its capital controls shortly after the Second World War, and moved to a floating exchange rate in 1950, well before the collapse of the Bretton Woods system.12 Despite the monetary independence that a floating exchange rate gave us, our long-term interest rates have always moved closely with those of the United States (Charts 7 and 8). This should not come as a surprise, given the close real economic ties between our economies and the highly integrated nature of our capital markets. The same is true of other countries now that they have shifted to open regimes similar to our own (Charts 9 and 10). Nevertheless, Canada has been able to control inflation and has been a successful inflation targeter since 1991, influencing economic activity and aggregate prices through adjustments in interest rates at the short end of the yield curve. These changes are in turn reflected, albeit with declining influence, out the yield curve to longer-dated instruments and, importantly, in the exchange rate. In this regard, the exchange rate serves as both an automatic buffer for internal and external shocks and as an integral part of the monetary policy transmission mechanism. Indeed, in a classic paper written in the early 1960s, Mundell (Mundell, 1963) showed how, in a world of complete asset substitutability and perfect capital mobility, real interest rates would be largely determined by international market forces with the exchange rate moving in response to changes in domestic monetary policy to provide most of the desired accommodation or tightening. Mundell’s model was extremely simple and included a number of heroic assumptions, but it accurately reflected important elements of the world in which open economies operate. R. A. Mundell, “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates,” The Canadian Journal of Economics and Political Science 29, no. 4 (1963): 475–485. Canada has had more experience with a floating exchange rate than any other major country. While Canada reverted to a fixed exchange rate in 1962, this proved to be temporary, and the dollar was allowed to float again in 1970. Overall, the Canadian dollar has floated for 55 of the past 63 years. BIS central bankers’ speeches Although authorities are able to exercise considerable influence over real interest rates, especially at the short end of the yield curve, and central banks are ultimately responsible for the rate of inflation in their economies, it is the exchange rate that does a great deal of the work. It is important to note, in this regard, that international arbitrage does not require complete interest rate equalization, just the equalization of (risk-adjusted) rates of return, including anticipated moves in the exchange rate. Control of the short rate is possible because monetary policy shifts the expected rate of currency appreciation or depreciation. The response of the Canadian economy to the Fed’s easing of UMP over the past five years has been exactly as one would expect. Asset purchases and Fed guidance put downward pressure on long-term interest rates in the United States and upward pressure on equity and other asset prices. The U.S. dollar depreciated as investors sought higher returns elsewhere, putting downward pressure on foreign interest rates and upward pressure on global asset prices and foreign currencies. Although the resulting upward pressure on the Canadian dollar served as a drag on domestic growth, the effects of this headwind were more than offset by the positive effects of stronger U.S. demand for our exports, higher asset prices, higher commodity prices and an improvement in our terms of trade.13 In other words, Fed easing was a net positive for Canada, making a difficult situation better. The process will work in reverse once the exit begins, but with one important difference: it will take place in the context of a strengthening U.S. economy. The improving underlying strength of the U.S. economy should more than compensate for the drag from higher interest rates. Stronger external demand, coupled with downward pressure on our currency and support for commodity prices from a global economic recovery, will provide the lift. Of course, the process is unlikely to unfold quite as neatly or mechanically as I have just described. Rudiger Dornbusch (Dornbush, 1976) extended Mundell’s framework to a dynamic environment and showed that forward-looking behaviour, together with price stickiness, could generate exchange rate overshooting.14 In the real world, there are a host of other reasons for exchange rates and other asset prices to overreact, including “animal spirits” and excessive exuberance. These should be transitory, however, with markets settling at levels consistent with fundamentals after a short period of time, assisted perhaps by some additional guidance. Conclusion The exit, when it comes, will not be without challenges both for those exiting and those feeling the effects of the exit. Nevertheless, this process should be viewed positively, as a sign that the global economy is well on the way to recovery and that it is time for interest rates to begin normalizing. If interest rates are kept low for too long, both price and financial stability would suffer. Markets seldom operate in a smooth, textbook, fashion. They are prone to excessive moves in response to breaking news or changes in sentiment. Although past experience with sharp interest rate moves might give cause for concern, especially among smaller economies with less-developed financial markets and institutions, a number of factors are working in favour of a smoother transition this time. On the impact of UMP on Canada, see Box 1 in the Bank of Canada’s October 2012 Monetary Policy Report. It should be noted that several other factors also influenced the Canadian-dollar exchange rate, including strong commodity prices and general weakness in the U.S. dollar. R. Dornbusch, “Expectations and Exchange Rate Dynamics,” Journal of Political Economy 84, no. 6 (1976): 1161–76. BIS central bankers’ speeches One of the most critical differences is the emphasis that is now put on clear communication and the increased awareness of the importance of transparency. The unwinding of UMP should be one of the best-telegraphed events in monetary history. A second important factor working in our favour is the tight alignment of incentives on the part of countries that are exiting as well as those that are affected by the process. No one wants it to proceed in a disorderly manner, and no one should want the exit to occur too early or too late. A third significant development from the perspective of EMDEs is the greatly improved circumstances in which these countries find themselves, in terms of their size and resilience. The impressive fiscal, financial and structural reforms that many of them have undertaken will put these economies in a far better position than they were 30, 20, or even 10 years ago. The same cannot be said of every country, of course. Much more remains to be done in many EMDEs as well as AEs. There can be no guarantee that the exit process will end positively for all countries. Vulnerabilities that were previously concealed by generous amounts of global liquidity may become more evident as normal monetary conditions are restored. All of this underscores the importance of countries getting their houses in order. 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 Stephen S Poloz, Governor of the Bank of Canada, to the Vancouver Board of Trade, Vancouver, British Columbia, 18 September 2013.
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Stephen S Poloz: Returning to natural economic growth Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Vancouver Board of Trade, Vancouver, British Columbia, 18 September 2013. * * * Introduction Thank you for that kind introduction and to all of you for coming this morning. It’s my pleasure to be here with the members and guests of the Vancouver Board of Trade. My focus this morning is the Canadian economy and, in particular, how it will return to natural growth. The story has three parts: Where are we now? Where are we going to end up? And how will we know we are on the right path? Where we are now I probably don’t need to tell anyone here that the recent global recession was the worst downturn since the Great Depression. In very short order, global GDP fell more than 3 per cent and millions of jobs were lost. In Canada, almost a half million jobs were lost and GDP fell by more than 4 per cent. The recession in Canada is now history, of course, thanks in large part to timely fiscal and monetary policy measures. We were the first of the G-7 to recover our recessionary decline in output and start expanding anew. We have regained all the jobs lost in the crisis and added almost 600,000 more. But everyone knows, we are not yet back to normal. Interest rates are at extraordinarily low levels. With unemployment above 7 per cent, there is still slack in the labour market. The export sector, close to 7 per cent below its pre-recession peak, still has a lot of ground to make up. Firm creation has been lagging… There’s something else. A characteristic of a naturally growing economy is a steady increase in the population of companies. However, for five years after the start of the crisis, we saw virtually no increase in the population of Canadian companies. This matters, a lot. Large, established companies certainly provide the foundation of economic growth. As they grow, or become more productive, or generate new ideas, everyone benefits. However, it is the creation of new companies that serves as a natural engine for growth. New ideas, new products and new ways of producing them are often the seeds of new companies. As they grow from one employee, to five, to 20 or more, they generate an outsized proportion of employment – in every economy, not just ours. New companies create new jobs, which create new incomes, which get spent, creating a virtuous circle of self-sustaining growth. That’s what makes it natural. Although the data on the population of firms are choppy, in the period from 2008 to 2012, there was almost no net creation of companies in Canada. Particularly hard hit have been Canada’s exporters, which were exposed to the full brunt of the global crisis. Their numbers out-and-out declined in the recession and, based on their ongoing weak output, have likely remained flat since then. The group most profoundly affected has been manufacturing exporters. BIS central bankers’ speeches … as is broader business investment Meanwhile, many existing businesses also seem hesitant to make major investments – and no wonder. Yes, there has been significant capacity added in the mining, oil and gas sectors. We have seen important, long-term investment in such projects as the oil sands, shale gas extraction here in British Columbia, and some mining projects. Indeed, during the recovery, this activity accounted for three-quarters of the contribution to growth made by investment. It helped return the share of overall business investment in GDP to close to historical levels. However, companies in other sectors have told us that they have held off on creating new capacity until they see more concrete signs of stronger demand. In the meantime, they have focused on small, targeted or niche projects – in other words, getting the most out of their existing capital. Such investments are important. But a more normal, post-recession evolution would show greater investment in the capital stock of firms across most sectors – not just mining, oil and gas. Confidence in short supply In our summer Business Outlook Survey, companies told us that uncertainty about the nature and timing of improving growth prospects is weighing on their investment decisions. Much uncertainty centres around U.S. fiscal and monetary policy, the future of Europe’s economy, and the sustainability of growth in China. But other factors also affect business confidence, including concerns about Canadian domestic demand, access to credit, and uncertainty about regulatory costs or government approvals. Together, these various elements of uncertainty create a sort of wedge, blocking companies from making optimal investment decisions. Understandably, Canadian firms have been reluctant to add new capacity until the U.S. economic recovery gains traction and is more certain. Given what firms have been through, it naturally would take a lot of confidence to expand. However, once there is a shift in sentiment, research shows that business decision-makers tend to react and move forward very quickly with their investment plans. Economists call this “animal spirits” because it is very hard to predict. Encouraging signs But some new data suggest we may be turning the corner. Recently published private surveys of business sentiment show some improvement. Further, financial market uncertainty has declined, according to Canadian and global indicators. Such measures of financial volatility may well be serving as proxies for actual world events or developments. We will be watching these closely to see if this improving trend continues. The Bank’s interviews with Canadian business leaders for our autumn Business Outlook Survey are being conducted right now. I am looking forward to learning about their views and perspectives – and if, and how, they may be changing. But perhaps the most exciting sign is that the population of Canadian companies is growing again. Today, there are some 40,000 more firms with at least one employee than there were last year at this time. This pace is considerably stronger than we would expect in normal, non-recessionary times and suggests that we may be replacing some of the firms that were lost in the recession with new ones. This is excellent news. We also know that most of the jobs created since the recession are in occupations requiring relatively high skill levels and are mostly in industries with above-average wages. What this will do is help contribute to the virtuous circle of higher incomes, more spending, and more jobs that is associated with natural growth. BIS central bankers’ speeches All of these signs are hopeful. They are signalling that we are on our way home. Where we are going: natural economic growth Let’s talk about that right now. What does home look like? This is a discussion about the future, so there are many unpredictable variables. However, I anticipate that the Canadian economy will normalize and growth will become natural, in contrast to the economic activity of the past six years, which has been fuelled by policy, including record-low interest rates. Natural growth will be self-generating and selfsustaining, and the economy will be growing at its potential, as its productive capacity expands. Inflation will be back to our target of 2 per cent. As I have said before, policy rates in Canada will be higher than they are today. We can expect that short-term interest rates, as is normal, will be above inflation. Long-term rates will settle into place along a natural, upward-sloping yield curve. We can anticipate a better balance in Canada between domestic and foreign demand. All components of GDP will contribute to growth, again, as normal. The unemployment rate in Canada can also be expected to come down to a more natural level. Consumer and government debt loads will be on a sustainable path. Firms will be generating self-sustained growth. In addition to these familiar elements, some things will look significantly different when we get home. We may be trading with new customers in new markets. Emerging markets are becoming more important to our exporters. Canadian companies have done a lot during this cycle to diversify into emerging markets, which are a growing – although still small – piece of our total trade. The nature of trade is also changing. More and more exporters are part of global value chains. Today, an exported good to the United States can ultimately end up being reexported to more than 100 other countries in a global value chain. Research shows that companies that are part of a global value chain, because they have specialized, have higher productivity, which means better-paying jobs. The mix of what we trade externally and what we sell here in Canada has already begun to evolve and undoubtedly will be different when we get home. The future will likely include a shift in the shares of manufacturing and services in the economy. Commodities may constitute a larger share than they do today. The sectors with the greatest anticipated job growth are both traditional and new: on the one hand, mining, oil and gas, and on the other, computer system design services. Employment is also expected to grow steadily in health care and transportation. We also have to be ready for surprises, when we get home, especially among the new emerging businesses. For example, in 1971 when the first microprocessor was invented, we didn’t even have microcomputers. Just as new technologies and industries emerged from previous recessions, this return to natural growth will include the development of new technologies, new firms and new jobs. Whole new sectors will take off; descriptions of new classes of jobs will be written; and people will be hired under brand-new, yet-to-be-defined job titles. For instance, until recently, who would have thought of a social media expert or a professional blogger as careers that our kids might aspire to? I'm not going to try to predict what new product, service or technology will deliver the next big boost to our economy and the labour force. But there are sectors that have the potential for ground-breaking innovations: 3-D printing, artificial intelligence and synthetic biology, among others. BIS central bankers’ speeches The path home Let me shift gears and talk about how we get home. How do we get to natural growth? What is the path? And how will we know we are on it? I have suggested before that there is a sequence of events we can anticipate: foreign demand will build; our exports will strengthen further; confidence will improve; existing companies will expand their production; companies will invest to increase capacity; and, new companies will be created. Evidence suggests we are now close to the tipping point from improving confidence into expanding capacity. We are seeing improvements in foreign demand. The Bank expects that strong increases in U.S. business and residential investment will particularly benefit the sectors of Canada’s export market that have lagged thus far, notably machinery and equipment and wood products. Long-term interest rates have recently begun to return to more normal levels, consistent with the strengthening U.S. economy and the anticipation that the U.S. Federal Reserve will begin to exit from its unconventional monetary policy. But it’s important to make the distinction between policy tightening and a slowing of the rate at which additional stimulus is being provided. Talk about “tapering” refers to the latter. I sometimes use a spaghetti-sauce model to help explain this. When the bubble burst in 2008, we were left with a crater, which is where we now find ourselves. If you look carefully at a pot of simmering spaghetti sauce, under every bubble there is a crater that’s equal in size. So, a 7-year bubble, a 7-year crater. Central banks have been filling that crater with liquidity, so we can row our boats across it. We need to make sure we’re getting to shore and not just hitting a rock. But when we get to the other side, when we get home and can climb out of the crater, central banks can gradually reduce the rate at which they add liquidity. That’s not policy tightening. Rather, it is another welcome sign that things are getting back to natural growth. It indicates that the underlying momentum of the U.S. economy is expected to hold. Further, the efforts of Canadian businesses to diversify into faster-growing emerging markets will pay off and will also help Canada’s export performance. Exports more than doubled over the past decade to countries that are not members of the Organisation for Economic Cooperation and Development and now account for 13 per cent of total exports. This growth has added roughly $38 billion to our exports, which is equivalent to adding a market bigger than the province of Nova Scotia to our economy in just a decade. Indeed, the Bank projects a solid pace of further improvement for our exports. This gathering momentum should help lift the confidence of Canada’s exporters and lead to more, and more broadly based, capacity-building investment. It should provide additional incentives for new start-up businesses. Historically, the lag between an improvement in exports and a pickup in investments has been about six months. Certainly, the preconditions are in place: the balance sheets of corporate Canada are healthy; the cost of capital is low; and credit appears to be accessible. The corporate environment is favourable: depending on which international consultant you believe, Canada is one of the top five, or the top three, or even the top two places in the world in which to launch a business. Stronger investment means more new jobs will be created. It means more capital and better tools for workers, which will increase labour productivity. It means more efficient ways of working and producing products and services. It means a resumption of the natural growth in the number of firms being created and more innovation and more creativity. This is the virtuous circle at work. This is what the Bank wants to see. It is what we expect to see. BIS central bankers’ speeches New demand creates new supply As firms gain confidence in the pickup of demand, they will invest more, which, by definition, adds to supply. In short, new demand will create new supply. As global demand improves and investment growth strengthens, we should see higher potential output growth – that is, an increase in the speed at which the Canadian economy can grow without causing inflationary pressures. With potential output higher and growing faster in response to stronger investment, the output gap – the gap between what the economy is capable of producing and what it is producing – could close later than if investment (and, ultimately, potential) did not respond to demand. The message here is that the economy should be able to support stronger activity without stoking inflation, as investment ticks upward. Such an endogenous response of potential to stronger demand would be natural, given the slack that we see in our labour market. The Bank will monitor closely the various indicators, including investment, productivity, labour participation and inflation, to determine the strength of potential output growth and the size of the output gap and the labour market gap. Rest assured, we will conduct monetary policy that is appropriate and consistent with achieving our target of 2 per cent inflation. Conclusion Many of the conditions needed to support a return to natural growth are already in place in Canada. These include a sound macroeconomic framework, a stable financial system, a well-educated workforce, and abundant natural resources. We are optimistic that the gathering momentum in foreign demand, especially in the United States, should help lift the confidence of Canada’s business leaders and exporters. We can expect the emergence of new products, new processes, new structures and new industries – in short, a resurgence of the creation side of the creative-destruction process we attribute to Joseph Schumpeter. It may be slow in coming, but it will emerge, and it will serve as a driving force of economic growth. The Bank is absolutely committed to keeping inflation predictable, stable and on target. This is sacrosanct. Our flexible inflation-targeting framework is the best contribution monetary policy can make so that Canadian households and businesses can make decisions about their financial future with confidence. In short, this is what we can do to help nurture a return to natural economic growth in Canada. BIS central bankers’ speeches
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Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, to the CFA Society (Ottawa), Ottawa, Ontario, 24 September 2013.
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Lawrence Schembri: Born of necessity and built to succeed – why Canada and the world need the Financial Stability Board Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, to the CFA Society (Ottawa), Ottawa, Ontario, 24 September 2013. * * * Introduction It has been just over five years since the worst days of the global financial crisis, which began with the dramatic collapse of Lehman Brothers in September 2008. While the subsequent Great Recession officially ended in June 2009, it hardly seems over, given the slow-motion recovery of the global economy. This is especially the case in Europe and the United States, where employment has not yet returned to pre-crisis levels. Looking back at Canada’s experience of the past five years, a key lesson from the crisis is that keeping our own house in order is not enough to shelter us from global financial storms. Yes, Canada’s recovery has been stronger than virtually all other advanced economies, thanks in part to our resilient financial system. Our sound monetary, fiscal and financial sector policies protected us from the worst of the financial crisis and recession. But make no mistake: Canada was still hit hard. Output fell by 3.5 per cent. And from October 2008 to October 2009, the unemployment rate rose from 6.1 per cent to 8.3 per cent. Harder lessons were learned at the international level. The breadth and depth of the crisis, and the speed with which it travelled around the globe, made world leaders sit up and take notice. In 2009, the G-20 identified the important task of reducing the likelihood of future financial crises and limiting their spillovers across borders. The Financial Stability Board (FSB) was set up to coordinate this work.1 Today, I am going to talk about the FSB, especially its coordinating role for Canada and the global economy. I will focus on: • why the FSB is needed, • how it works, and • its accomplishments to date and plans for the future. I will also discuss implications of the FSB’s financial reform agenda for Canada. Why we need the FSB From my perspective, the FSB is a unique international organization that has certain qualities that many associate with Canadians, qualities I believe will help ensure its success in making the global financial system more resilient. A resilient global financial system is not an end in itself, but a necessary foundation for strong, sustainable and balanced global economic growth, leading to higher employment and improved living standards. The FSB was born of necessity in the aftermath of the financial crisis. Its raison d’être stems from one overarching fact: the global financial system is highly integrated.2 Financial institutions and markets are interconnected and interdependent within and across various The FSB grew out of the Financial Stability Forum (FSF), founded in 1999 by the G-7 in the wake of the financial crises in Asia, Latin America and Russia. Bank of Canada Deputy Governor Timothy Lane, in his 2013 speech, “Financial Stability in One Country?” argues that because of global financial integration, it is impossible to achieve financial stability in one jurisdiction by focusing exclusively on domestic considerations. BIS central bankers’ speeches sectors, including banking, insurance, and pension and investment funds, and, increasingly, across national jurisdictions. Thus, to achieve a comprehensive and coherent approach to the financial regulation and oversight necessary to attain the global public good of financial stability, coordination is essential across countries, across all of the elements of the reforms, and across many different regulators and supervisors. Failure to coordinate would lead to the fragmentation of the financial system, which would impede the global recovery. This need for effective coordination is why the G-20 established the FSB in 2009.3 What is the FSB? The FSB is not only the newest, it is by far the smallest – with only about 25 full-time staff – and probably the least well known of the major international organizations.4 These include such postwar heavyweights as the International Monetary Fund (IMF), the World Bank and the Organisation for Economic Co-operation and Development (OECD). It is an international organization like no other: • Its membership is composed of national financial authorities from 24 countries, including G-20 members and other significant financial jurisdictions such as Switzerland and Singapore.5 An important innovation is that it also includes international financial institutions such as the IMF, the World Bank and the Bank for International Settlements, as well as international bodies that set standards for banking, insurance, securities and accounting.6 • The FSB punches well above its weight by levering the knowledge of its 70 member agencies, which are home to several thousand financial sector experts. It is these experts who do most of the heavy lifting, sitting on committees and working groups to develop policy and conduct peer reviews of implementation, supported by the small FSB Secretariat. • At the FSB, decision making is based on consensus. The process of policy development allows members to input their views at each stage, thereby ensuring collective ownership of the policy decisions. The FSB relies on moral suasion, or what political scientists like to call “soft power.” As such, the FSB wields no legal sanctions but encourages countries to adhere to global standards and promotes a “race to the top” through disclosure and peer pressure. The FSB or its member standard-setting bodies regularly produce peer-led, country-by-country assessments of compliance with global standards. The FSB charter affirms “the FSB’s role in coordinating at the international level the work of national financial authorities and international standard setting bodies in developing and promoting the implementation of effective regulatory, supervisory and other financial sector policies in the interest of global financial stability”. See: http://www.financialstabilityboard.org/publications/r_120809.pdf. The majority of FSB staff members are on temporary secondments from member institutions. In addition to the 70 member agencies from 24 member countries, the FSB has six regional consultative groups to disseminate information and collect feedback from an additional 70 non-member countries. Broader implementation of global financial standards is important for supporting the ongoing process of global financial and economic integration. These standard-setting bodies include the Basel Committee on Banking Supervision (BCBS), the International Association of Insurance Supervisors (IAIS), the International Organization of Securities Commissions (IOSCO), the Committee on Payment and Settlement Systems (CPSS), and the International Accounting Standards Board (IASB). BIS central bankers’ speeches • Because the FSB is a creation of the G-20 Leaders, it has the weight of the G-20 behind it. The G-20 provides direction and receives regular progress updates from the FSB on the financial reform agenda. This close working relationship gives the FSB the political leverage it needs to be effective. In short, the FSB was designed to succeed in its coordinating role. It is an efficient and inclusive international organization that can act nimbly to coordinate the efforts needed to address serious financial vulnerabilities.7 The FSB may be small, but it is powerful, undertaking work of great significance to create a resilient, competitive and integrated global financial system, which is necessary to support a rapidly evolving global economy. Countries such as Canada, with open global financial markets and internationally active financial institutions, especially benefit from the work of the FSB. As I mentioned earlier, the FSB also embodies characteristics that are important to Canadians. It is consultative, guided by common sense and consensus; co-operative; and respectful of process. This perhaps should not be surprising, given that senior officials from the Bank of Canada and the Office of the Superintendent of Financial Institutions (OSFI) have played prominent leadership roles at the FSB.8 How does the FSB work? The FSB works to achieve its goal of global financial stability through four main functions, or steps, which I call the financial policy cycle: i. Identify and assess financial vulnerabilities. The recent financial crisis pinpointed several, and I will discuss those in a moment. ii. Develop the necessary policies or global standards to address these vulnerabilities. iii. Monitor the implementation of these standards by national jurisdictions to ensure consistency; and iv. Assess the effectiveness of the regulation, including any unintended adverse consequences on financial market outcomes. The FSB is organized around these four functions, with standing committees of FSB members who carry out the necessary work.9 Working with the BCBS, the FSB was able to use its soft-power approach, including its political leverage with the G-20, to get the new Basel III capital framework developed and largely put in place in five years. In contrast, it took almost twice as long to reach the same stage with the earlier capital framework. Former Bank of Canada Governor and current Bank of England Governor Mark Carney has served as the FSB Chair since November 2011; Senior Deputy Governor Tiff Macklem was Chair of the FSB’s Standing Committee on Standards Implementation from June 2009 to April 2013; and Julie Dickson, Superintendent of OSFI, has chaired the FSB’s Committee on Supervisory Intensity and Effectiveness since its creation in 2010. See M. Carney, “Rebuilding Trust in Global Banking” (speech to the 7th Annual Thomas d’Aquino Lecture on Leadership, London, Ontario, 25 February 2013); J. Dickson, Remarks to the Institute of Internal Auditors, Toronto, 31 May 2013, and Remarks to the International Institute of Finance, Madrid, 21 May 2012; and T. Macklem, “Raising the House of Reform” (speech to the Rotman Institute for International Business, Toronto, 7 February 2012). The Standing Committee on Assessment of Vulnerabilities (SCAV) conducts regular monitoring exercises to identify and assess vulnerabilities; the Standing Committee on Supervisory and Regulatory Cooperation (SRC) decides how best to address these vulnerabilities through policy development; and the Standing Committee on Standards Implementation (SCSI) monitors implementation and assesses effectiveness. The work of these committees is directed and overseen by the Steering Committee and the Plenary, the FSB’s decision-making body. BIS central bankers’ speeches Let me illustrate the execution of the first two steps in this policy cycle by outlining four principal weaknesses in the global financial system exposed by the financial crisis and how the FSB responded. (i) Inadequately capitalized banks In 2008, major banks in the United States, the United Kingdom and continental Europe either failed or were publicly rescued, in large part because they had insufficient levels of good-quality capital to absorb the losses incurred from taking on too much credit risk. Building more resilient banks To address this weakness and build more resilient banks, the Basel Committee on Banking Supervision, an FSB member, developed the Basel III rules to strengthen the quantity and quality of bank capital. These rules call for more than tripling the required amount of capital.10 This updated Basel framework will be further buttressed by enhanced liquidity rules, a backstop leverage ratio similar to one that has been used in Canada, a countercyclical capital buffer and stronger supervision to enforce adoption by banks. (ii) Financial institutions that were considered “too big to fail” Large financial institutions, like Lehman Brothers and AIG, were able to take on excessive risk because they were seen as being “too big to fail.” Consequently, when risks were realized, the actual or looming failure of these institutions weakened investor confidence, spread uncertainty and severely disrupted the global financial system. To stem the massive contagion, many of these institutions had to be bailed out at taxpayers’ expense, which was patently unfair. Losses should not be socialized; they should be borne by those who profited from taking the risk. Ending “too big to fail” To end “too big to fail,” the FSB has adopted a three-pronged approach, known as the Systemically Important Financial Institution (SIFI) framework. The three key elements in development are: • higher capital requirements for financial institutions that are deemed to be systemically important;11 • standards for the effective resolution of such institutions that eliminate the need for taxpayer bailouts and minimize the disruption to the financial system; and12 • more intense and more effective supervisory oversight. (iii) Shadow banking Credit intermediation activities outside the perimeter of traditional regulation are often referred to as “shadow banking.” I prefer to call them “market-based finance” because they include securitization, repurchase agreements (repos) and money market funds, which are The minimum requirement for common equity has increased from 2 per cent to 4.5 per cent, and will rise to 7 per cent when the new capital conservation buffer is added. In 2011, the FSB identified an initial group of global systemically important financial institutions (G-SIFIs). The current group of 28 global systemically important banks (G-SIBs) will be updated in November 2013. The FSB and other standard-setting bodies are extending the SIFI framework to domestic systemically important banks (D-SIBs). National authorities should begin to apply phase-in arrangements for the requirements for D-SIBs as of January 2016. See: http://www.financialstabilityboard.org/publications/r_121031ac.pdf. An initial list of global systemically important insurers was published in July 2013. In 2011, the FSB published the “Key Attributes of Effective Resolution Regimes for Financial Institutions”, which set out how authorities could resolve financial institutions in an orderly manner. BIS central bankers’ speeches important and useful forms of credit intermediation. If they are not properly regulated, however, these activities are subject to the same sort of systemic risks as banks, including contagious runs. The worst example from the crisis was the faulty securitization of U.S. subprime mortgages. Transforming shadow banking into more resilient market-based finance As measures are put in place to make banks more resilient, there are legitimate concerns that greater scrutiny and regulation of the traditional banking sector could result in more risky activities migrating beyond the regulatory perimeter to the shadow banking sector. First, as part of its ongoing work on vulnerabilities assessment, the FSB has established a framework for monitoring shadow banking to identify and evaluate emerging risks. Second, as part of its efforts to ensure that shadow banking is transformed into more resilient market-based finance, the FSB, at the G-20 meetings in St. Petersburg earlier this month, presented a set of recommendations for the regulation of shadow banking. These recommendations are aimed at increasing transparency, reducing moral hazard and limiting maturity and liquidity transformation, with the overall goal of striking a balance between the efficiency and competition these activities offer and the bank-like risks they pose. (iv) Critical financial markets seizing up An important example of a financial market seizing up was the US$600 trillion over-thecounter (OTC) derivatives market, which is a critical source of funding and risk management, especially for major financial institutions. While the OTC derivatives market was not an underlying cause of the financial crisis, its complexity, opacity and interconnectedness made the crisis worse. Creating more robust and continuous OTC derivatives markets To increase the transparency and reduce the systemic risk in these markets, the FSB has coordinated the development of policies to ensure that transactions are reported to trade repositories and that standardized OTC derivatives are cleared through central counterparties, or CCPs. A central counterparty acts as a buyer to every seller and a seller to every buyer for the financial transactions that it clears. This increases transparency and reduces counterparty credit risk.13 Next step: implementation The third step in the FSB’s policy cycle is the implementation of these global policies or standards at the national level. This is the most difficult and time-consuming step because it means taking global minimum standards or principles for financial sector regulation and adapting them for local implementation. This is where the rubber hits the road. The stated goal of the FSB is for “full, timely and consistent” implementation of global standards at the national level. Each of these adjectives is essential: they underscore the importance of a coherent and comprehensive approach to regulation to create a level regulatory playing field across jurisdictions. The FSB and its member agencies are developing a multi-year framework to monitor the implementation of these reforms. Implementation at the national level typically requires several steps, including revising existing laws or passing new legislation, and developing rules or guidelines for market Central counterparties concentrate and mutualize risk but don’t eliminate it. Thus, they need stringent standards for risk management and oversight. BIS central bankers’ speeches participants. Consistency is difficult to achieve because jurisdictions have different legal and institutional frameworks that must be modified to meet new global standards. Where is Canada in the implementation process? Because Canada’s regulatory and supervisory frameworks were relatively well developed going into the crisis, the extent of the reforms needed here is less profound, but still important. Nonetheless, Canada is leading by example. It was one of the first jurisdictions to implement the Basel III capital framework.14 At the beginning of this year, all major Canadian banks were expected to meet the stringent Basel III requirements as specified by OSFI – six years ahead of the agreed deadline of 1 January 2019.15 Canada has also made progress in addressing the problem of too big to fail. OSFI recently designated Canada’s six largest banks as domestic systemically important banks and required that they hold 1 per cent more capital and be more closely supervised.16 Market-based finance is generally viewed as less vulnerable in Canada than in other jurisdictions, and the Bank of Canada and our partner agencies want to keep it that way. To that end, we have participated fully in the FSB’s shadow banking monitoring exercise and will work together to consider how best to implement recent FSB recommendations.17,18 Finally, we have moved forward in the implementation of the G-20 commitments for OTC derivatives. In fact, the Bank of Canada has joined a multilateral arrangement for the co-operative oversight of LCH.Clearnet’s SwapClear, a global central counterparty based in London, England, and the dominant counterparty for clearing Canadian interest rate swaps.19 As I noted, the Bank is working closely with other agencies at the federal and provincial levels to implement the new global standards within a framework that is best suited for Canada. Since the end of 2007, the major Canadian banks have increased their common equity capital by 70 per cent, or $67 billion. The capital levels of Canada’s major banks are now at roughly 9 per cent or higher. Canadian banks are also moving ahead to implement the recommendations of the FSB-sponsored, private-sector-led Enhanced Disclosure Task Force. This task force is providing principles and recommendations for improved bank risk disclosures so that investors and others will have timely and useful information about the risk undertaken by banks. This report is available at: http://www.financialstabilityboard.org/press/pr_121029.pdf. The recent federal budget proposed that these banks would be subject to a system of bail-in debt that could be used to recapitalize them should their capital levels fall below the level of non-viability. This proposal represents an important step in implementing the FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions”. T. Gravelle, T. Grieder and S. Lavoie, “Monitoring and Assessing Risks in Canada’s Shadow Banking Sector”, Bank of Canada Financial System Review (June 2013): 55?63. Canada has gone beyond these shadow banking recommendations by establishing and promoting the use of a central counterparty for repurchase agreements to reduce counterparty and overall systemic risk and to use collateral efficiently by netting exposures. As of 2 April 2013, the Bank of Canada acted under the Payment Clearing and Settlement Act to designate SwapClear as systemically important. Designation brings the system under the formal oversight of the Bank of Canada. It also provides the system’s clearing and settlement rules with legal protections under Canadian law, including those pertaining to netting, finality of payment and finality of settlement. See http://www.bankofcanada.ca/2013/03/publications/press-releases/bank-canada-designates-swapclearpayment-clearing/. BIS central bankers’ speeches Closing remarks – maintaining momentum As the dark days of the global financial crisis slowly fade in our collective memory, the real challenge is to maintain the momentum of reform, and, in particular, to confront difficult cross-border issues, especially with respect to resolving international financial institutions and regulating global financial markets. The groundwork is there. The FSB has fostered the necessary co-operation and has made solid progress in coordinating the development of appropriate global policies to address the main weaknesses exposed by the crisis. It is also pushing forward in other directions, including reforming financial benchmarks, like LIBOR, improving data collection and information exchange, and achieving a common global set of high-quality accounting standards. The G-20 Leaders have recognized the importance of the FSB’s work and last year, at the Los Cabos Summit, took steps to further strengthen the FSB’s role in coordinating the development and implementation of financial reforms.20 At the recent G-20 Summit, Leaders once again affirmed the FSB-led financial reform agenda. Nonetheless, some have argued that, given the weak recovery, now is not the time for the broad financial sector reform being promoted by the FSB. That argument is wrongheaded for several reasons. First, financial stability is an important precondition for economic growth. In particular, the countries with the strongest financial systems were the first to recover. Indeed, the experience of the United States is an important example. U.S. officials took bold measures to stress test and recapitalize their banking system. Now, they are reaping the benefits as the recovery in the United States gathers momentum. Second, the overall coherence of the reforms, their proportionality relative to the risks and their macroeconomic effects are considered before the reforms are finalized and implemented.21 Third, concerns about possible adverse effects of these reforms on the financial system and, in particular, on market functioning, are being addressed by the fourth step in the FSB policy cycle. The FSB regularly and closely monitors the effectiveness of new regulations, keeping an eye out for any material unintended consequences. As we know only too well, the global economy and, in particular, the global financial system, are highly integrated. Canada learned that lesson during the recent financial crisis, when adverse shocks spread rapidly through financial channels. We also know that the pace of global financial and economic integration will continue unabated. Thus, to ensure the resilience of the global financial system and, ultimately, of the global economy, we need a global organization that can coordinate the necessary efforts, especially across borders, to tackle emerging gaps and weaknesses in financial regulation and supervision and thereby help to prevent future crises like the one we just experienced. For this we have the FSB – a post-financial-crisis institution for a post-financial-crisis world. Thank you very much. The G-20 Leaders agreed that the FSB’s mandate should be strengthened; that it be given permanent legal standing; and that its capacity and resources be increased. 21. See “Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements”, Bank for International Settlements, December 2010; “Assessment of the Macroeconomic Impact of Higher Loss Absorbency for Global Systemically Important Banks”, Bank for International Settlements, October 2011, and “Macroeconomic Impact Assessment of OTC Derivatives Regulatory Reforms”, Bank for International Settlements, August 2013. BIS central bankers’ speeches
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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the Economic Club of Canada, Toronto, 1 October 2013.
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Tiff Macklem: Global growth and the prospects for Canada’s exports Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the Economic Club of Canada, Toronto, 1 October 2013. * * * Introduction Good afternoon and thank you for the invitation to address the Economic Club of Canada. Canada has thrived by being open to the world, and having the world open to us. Our citizens hail from, travel to, and work in countries across the globe. We participate in global governance, offer our assistance and expertise in disasters and conflict, and, most importantly for our prosperity, we are traders. Historically, exports have been an important driver of Canada’s economic growth. Today, they account for about a third of our national income. This is my topic today – exports. How is global demand likely to shape our export performance, and what should we be doing to take full advantage of an expanding world market? Canada’s export performance To cultivate and serve international markets, our exporters have been smart, creative and competitive. They need to be. Canadian exporters operate in a global marketplace with aggressive competitors and a global economy continually in flux. Changes to the geography and composition of growth over the past dozen years have been nothing less than transformative. Growth in the emerging-market and developing economies is now outpacing that of the advanced economies, creating both new markets and new sources of competition. And the knowledge economy is becoming an important source of trade in services. The financial crisis has, in many ways, only accelerated these changes. Our exporters are adapting but it has been gut-wrenching. In the wake of the financial crisis, our exports were harder hit than in any post-war recession, decreasing by about 17 per cent over three quarters. This was more than triple the decline experienced in the 1990–91 recession. Many Canadian exporters either went out of business or turned inward to Canadian markets. From the peak in 2008 to the trough in 2010, the number of exporters fell nearly 20 per cent, dropping by almost 9,000 firms. After a surge in the second half of 2011, exports have again lost momentum, falling back by about 1.2 per cent. They remain 6.5 per cent or $35 billion below their pre-recession peak, and more than $130 billion below where they would be in an average export recovery (Chart 1). There is much lost ground to make up. This weakness largely reflects anemic foreign demand – this is the weakest post-war U.S. recovery. But it is being compounded by a longer-term trend: our share of world exports has been in decline for more than a decade. Since 2000, Canada’s share has fallen from about 4.5 per cent to about 2.5 per cent.1 Part of this decline is the inevitable consequence of the entry of China into global markets. But even allowing for this, Canada has fared poorly. Our loss of global trade share has been the second largest in the G-20. D. de Munnik, J. Jacob, and W. Sze, “The Evolution of Canada’s Global Export Market Share,” Working Paper No. 2012-31, Bank of Canada, October 2012. BIS central bankers’ speeches Following the financial crisis, the Bank’s strategy for monetary policy was to support domestic demand while the recovery in exports took hold. The first part of the strategy worked. Final domestic demand recovered quickly in Canada. But a side effect has been the emergence of imbalances in the household sector, reflected in rising household leverage, stretched valuations in a number of housing markets, and an increase in the incidence of highly indebted households. Today, there is a more constructive evolution of those household imbalances. This is good news. It reduces the risk of an abrupt and painful correction down the road. But this new-found and welcome household prudence is dampening growth. To replace this growth, we need a rotation in demand toward exports and business investment. Unfortunately, this rotation has proven elusive. This is consequential – growth in Canada has slowed. In the year leading up to this past June, growth averaged only 1.4 per cent, compared to 2.6 per cent the year before. With Canada’s potential output estimated to be growing at about 2 per cent, growth in demand has not kept pace with the expansion in production capacity, and economic slack has increased. To absorb the current material degree of slack in the economy, demand needs to grow measurably faster than supply. That means growth of at least 2½ per cent. The Bank is currently revising its forecast, and we will publish our latest outlook in our October Monetary Policy Report. But in broad strokes, we expect household and government spending together to contribute about 1½ percentage points of growth. So to reach at least 2½ per cent GDP growth, we will need at least a 1 percentage point contribution to growth from net exports and investment. That means together exports and investment need to grow by at least about 4 per cent after taking into account their import content. In the past year, net exports and investment made no contribution to growth. Conditions are propitious for business investment to accelerate. Corporate balance sheets are exceptionally strong, and corporate borrowing rates remain very low, even if they are off their troughs. But investment is unlikely to accelerate until businesses are confident that demand is picking up. The key is exports. As firms see their order books filling up, they will unlock their investment plans. The typical lag between a pick up in exports and an acceleration in investment is about six months. So the crucial question is: What are the prospects for our exports? To address this question, I will start by reviewing the outlook for global growth and the demand for our exports of goods and services. Global outlook Advanced economies are contributing more to growth The U.S. economy is reaping the benefits of bold measures to repair its financial system and exceptionally expansionary monetary policy. Private demand has gained momentum, despite considerable fiscal drag imposed by tax increases and sequestration cuts and a sluggish labour market. Household deleveraging in the United States is well advanced. Through a combination of defaults, increased savings and gains in asset valuation in house and equity prices, household net worth is now back to 2007 levels (Chart 2). BIS central bankers’ speeches Housing starts and resales are recovering, and house prices are now up almost 18 per cent from their trough. The once mighty U.S. consumer is coming back, albeit more prudently, and this is underpinning growth excluding fiscal policy in the 3½ to 4 per cent range. Headline GDP growth, however, is much weaker, owing to significant fiscal drag, which we estimate will subtract 1¾ percentage points from growth this year (Chart 3). While this is dampening GDP growth, our exports are more geared to private U.S. demand, which is stronger. The recovery in housing, in particular, is creating new demand for Canadian exports of lumber and building supplies. In Japan, the Abenomics “Three Arrows” policy revolution has so far produced impressive results.2 The immediate impact was to push equity prices significantly higher, depreciate the yen by roughly 20 per cent, generate expectations of positive inflation and push real longterm interest rates into negative territory. This is now translating into faster growth, which averaged close to 4 per cent, at annual rates, in the first half of this year. To sustain this momentum, bold monetary policy measures will need to be followed by more difficult structural reforms – the third arrow. In Europe, there are early signs of recovery. The intersecting downward spirals of fiscal austerity, bank deleveraging, declining economic activity, increasing government debt burdens and rising non-performing loans are abating. Euro area growth is now positive and, encouragingly, the structural imbalances at the root of the euro crisis are also showing signs of improvement. The substantial current account deficits in the peripheral countries have been largely eliminated (Chart 4) and, more significantly, the competitiveness of the peripheral countries relative to Germany has begun to improve (Chart 5). This bodes well. Nevertheless, Europe is far from being out of the woods. Growth is likely to remain subdued and downside risks remain. Still, the situation is better than it was six months ago, and much better than a year ago. Growth in China looks solid, but other emerging markets are losing momentum In China, growth has slowed to a still-solid pace of 7½ per cent, and confidence is improving. Growth is being spurred by robust investment, particularly in infrastructure, as well as expansionary credit conditions. Supported by “consumption-friendly” structural reforms, growth is expected to rotate toward consumption, although this process is likely to be very gradual. In contrast, a number of other emerging markets have experienced increased financial volatility and weakening growth prospects. Against the background of a steepening U.S. yield curve, there were broad-based capital outflows across emerging markets through June and July as investors pulled back from risk (Chart 6). Since then, markets have become more discriminating, focusing on emerging markets that appear more vulnerable owing to a combination of current account deficits, inflation and slower growth (Chart 7). While there has been some stabilization in the financial markets, credit spreads have widened in these emerging-market countries, and their currencies have depreciated sharply (Chart 8). To limit the depreciation, authorities in affected countries have responded with a series of measures to stem capital outflows, including currency interventions, capital controls and higher policy interest rates. While such measures may provide temporary relief, they are not without cost. Ultimately, the best defense is undertaking the fundamental reforms necessary to putting one’s own house in order. The “three arrows” are: (i) adoption of a 2 per cent inflation target with unprecedented quantitative monetary easing to achieve the target within approximately 2 years; (ii) substantial fiscal stimulus in the near term followed by fiscal consolidation starting mid-2014; and (iii) structural reforms to promote long-term growth. BIS central bankers’ speeches Expectations of stable, solid growth in China will support commodity prices, which, overall, remain high by historical standards. However, the recent slowing in other emerging markets, combined with some retreat from risky assets, has exerted downward pressure on many commodity prices in recent months, particularly base metals. In aggregate, commodity prices are expected to remain relatively stable through 2015, with the effects of modest expected declines in oil prices offset by a gradual rise in the prices of non-energy commodities. How will these global developments affect our exports? To address this question, I will look at our exports from three perspectives: our trade geography, or who we sell to; our competitiveness in global markets; and our product mix. Our trade geography Over the past dozen years, our trade geography has worked against us because our major trading partners have been growing more slowly than the global economy. From 2001 to 2007, the rise of China and other emerging-market countries outpaced growth in U.S. demand. The crisis only magnified this. Emerging markets now account for 80 per cent of global growth (Chart 9). But only 12 per cent of our exports go directly to fast-growing emerging markets while 85 per cent go to slow-growing advanced economies. Compared with our peers, Canada’s direct exposure to emerging markets is tiny when measured as a share of exports (Chart 10). To illustrate the magnitude of this trade geography effect, suppose Canada had the same level of exposure as the United States to emerging markets (Chart 11). Foreign demand for our exports would be $60 billion higher. Going forward, our trade geography should improve as the recovery in advanced economies, and particularly the United States, gains momentum. Emerging markets are likely to remain the principal source of growth in the next several years, but as the United States and other advanced economies recover, they are expected to regain at least part of the share of global growth that they lost in recent years (as projected in Chart 9). This will be positive for our exports. At the same time, Canadian exporters are developing new markets in the fastest growing emerging markets. One-third of firms report they have already started exporting to new markets in the past two years, and about half plan to expand into new countries over the next two years. The top two destinations are Brazil and China.3 In addition to direct exports to developing economies, Canadian exporters are also embedded in global supply chains. Participating in supply chains means that Canadian businesses benefit from trade with countries such as India and China not only by selling directly to them, but also by supplying firms in the United States and other advanced economies that are selling to the emerging markets. As the pendulum swings from offshoring to on-shoring, Canadian firms need to secure and grow their presence in global supply chains. Our competitiveness A second factor influencing our exports is competitiveness. Between 2000 and 2012, the labour cost of producing a unit of output in Canada compared with the United States, adjusted for the exchange rate, increased by 75 per cent (Chart 12). The majority of this loss of competitiveness reflects the appreciation of the Canadian dollar (shown in blue), but weak productivity growth in Canada relative to the United States also played a significant role (shown in green). Export Development Canada’s semi-annual survey of Canadian companies, released June 27, 2013. BIS central bankers’ speeches This decline in competitiveness is manifest in our shrinking share of the U.S. market. Not only did the U.S. import market contract relative to the rest of the world, Canada’s share of that market shrank (Chart 13). What if we hadn’t lost competitiveness? What would our exports be had our competitiveness stayed at its 2002 level? If Canada’s exports had grown in tandem with those of the U.S. and global economies – in other words, taking the weakness of the global economy as a given and excluding oil – our goods exports would have been $71 billion higher (Chart 14). There are many factors that affect business investment and productivity, including access to risk capital, the regulatory environment, infrastructure and skills mismatches. This makes productivity particularly hard to predict. But looking ahead, stronger exports should encourage more investment and this, in turn, should increase productivity. As firms fully utilize existing capital, productivity can be expected to rise. And new investment typically embodies new technologies, so as this new investment comes on line, workers will have more and better capital to work with. Better tools help make workers more productive, which should improve our competitiveness. Our product mix The third factor is what we export – our product mix. Here, there are two forces at play, which have been moving in opposite directions. From 2000 to 2007, strong growth in advanced and emerging economies created strong global demand for machinery and equipment and consumer goods. This shift in the composition of global demand did not play to Canada’s strengths. Machinery and equipment and consumer goods are a smaller proportion of our exports than in the average world export basket. Commodities, on the other hand, have worked in the other direction. In the last several years, the boost from the commodity intensity of our exports has turned the product mix effect to a net positive for Canada, with the rise in our energy exports more than fully offsetting the drag from machinery and equipment (Chart 15). Energy commodities have become an increasingly important share of our exports. In 2000, energy made up 11 per cent of our exports. Today it is almost 20 per cent. And oil is now by far our most important commodity. Its share of commodity production roughly doubled in the past decade, to close to 50 per cent today (Chart 16). But recently, energy transportation bottlenecks in North America have been limiting this positive product mix effect. While oil sands production is rising steadily, transportation capacity has become increasingly problematic. All realistic scenarios for U.S. energy independence include Canadian crude production. But we have to get it there. In the coming years our product mix is likely to provide less of a boost than it has over the past five years. As I mentioned earlier, commodity prices are expected to remain relatively stable through 2015 but some of our export sectors that particularly suffered, such as forestry, should pick up. Services exports: a growing opportunity Finally, let me say a few words about our exports of services. We tend to focus on exports of goods, but services have the potential to become a more important source of Canadian national income. Services already account for 15 per cent or $75 billion of our exports. This is more than either motor vehicles and parts or machinery and equipment. And unlike motor vehicles and machinery and equipment, our services exports were relatively stable throughout the recession (Chart 17). BIS central bankers’ speeches The global growth of the knowledge economy is changing the composition of our service exports. We have been – and are – selling the products of our intellectual labours to the world. This includes management services, computer services and information, financial services and engineering services. Services being exported range from new apps to security and training software, data analytics, multimedia, online services, and social media management systems. More than 60 per cent or $46 billion of our service exports are commercial services, some 40 per cent of which are purchased by non-U.S. clients. About 50 per cent of financial and insurance services, one of the largest categories of service exports, go to markets outside the United States. And while exports of management services to the United States and the European Union have slowed since 2005, they have grown in other countries. This trend underscores one of the significant strengths of our services exports: they are more diversified than our goods exports. More than 20 per cent are to non-OECD countries. Conclusion Let me try to summarize. To put a meaningful dent in the remaining slack in the Canadian economy, we need annual growth of at least 2½ per cent. Achieving this requires a rotation in demand toward exports and business investment. The conditions are in place for investment to accelerate but, in an uncertain world, firms need to see demand pick up before they will commit. An improving global outlook, particularly for advanced economies, should boost our exports. To fully reap the benefits of this lift, we must strengthen our competitiveness while developing new markets and securing our position in global supply chains. As we said in our September 4 policy statement, uncertain global conditions appear to be delaying the rotation towards exports and investment. Near-term growth now looks a little less choppy than initially projected. We are now expecting growth in the third and fourth quarters of this year to be in the 2 to 2½ per cent range before strengthening next year as the rotation to exports and investment gains momentum. There is a risk that this rotation is delayed further. At the same time, some recent surveys and other evidence, including the pick-up in firm creation, suggest that firms are becoming more optimistic. And once the sequence of stronger exports, rising confidence, increased investment and stronger productivity is launched, it could well gain traction faster than expected. We will be monitoring this dynamic closely. With inflation subdued, monetary policy remains highly stimulative to provide time for the recovery in exports and investment to take hold. This is not the first time we have faced the challenge of restoring our exports against shifting global tides. From beaver pelts to building materials, we have experienced plunges in the markets for our goods. We recovered by developing new goods and services and entering new markets. There can be no doubt that we have the entrepreneurial spirit, the skills, the educated work force and the expertise to compete successfully in the global marketplace. But that does not make it easy. 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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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 23 October 2013.
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Stephen S Poloz: Summary of the latest Monetary Policy Report Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 23 October 2013. * * * 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 is expected to expand modestly in 2013. However, its nearterm dynamic has changed and the composition of growth is now slightly less favourable for Canada. • The U.S. economy is softer than expected. But as fiscal headwinds dissipate and household deleveraging ends, growth should accelerate through 2014 and 2015. • Overall, the global economy is projected to grow by 2.8 per cent in 2013 and accelerate to 3.4 per cent in 2014 and 3.6 per cent in 2015. • In Canada, uncertain global and domestic economic conditions are delaying the pick-up in exports and business investment. This leaves the level of economic activity lower than the Bank had been expecting. • While household spending remains solid, slower growth of household credit and higher mortgage interest rates point to a gradual unwinding of household imbalances. • The Bank expects that a better balance between domestic and foreign demand will be achieved over time and that growth will become more self-sustaining. But this will take longer than previously projected. • Real GDP growth is projected to increase from 1.6 per cent this year to 2.3 per cent next year and 2.6 per cent in 2015. The Bank expects that the economy will return gradually to full production capacity, around the end of 2015. • Inflation in Canada has remained low in recent months, reflecting the significant slack in the economy, heightened competition in the retail sector, and other sectorspecific factors. • With larger and more persistent excess supply in the economy, both total CPI and core inflation are expected to return more gradually to 2 per cent, around the end of 2015. • The outlook for inflation is subject to several risks emanating from both the external important that we are not just aware of these risks, but that we also take them on board as we consider the appropriate course for monetary policy. • We have identified two important external risks. An upside risk to inflation in Canada that emanates from the external environment is the risk of more-robust economic growth than projected in the advanced economies. Greater global demand would in turn translate into higher exports for Canada and rising commodity prices, which would support higher incomes and spending. • A second important external risk is a more protracted and difficult euro-area recovery. Since Canada’s direct trade links to the euro area are limited, the effects would be felt mainly through confidence and financial channels, as well as through indirect trade links. • We have also identified three important domestic risks. BIS central bankers’ speeches • First, there is a possibility that, for a given projection for global growth, exports could be even weaker than assumed. This is a risk that could materialize if competitiveness challenges were greater than anticipated and would result in an even larger loss of market share. • Second, there is a risk on the upside that, as confidence returns, domestic momentum builds faster than expected. Once the recovery in foreign demand becomes more solidly entrenched, and with domestic demand continuing to grow at a moderate pace, business sentiment could improve rapidly. • The third important domestic risk remains a disorderly unwinding of household sector imbalances, which are still elevated. The continued slowing in household credit and the rise in mortgage interest rates point to a gradual unwinding of household imbalances, but recent data suggest some risk of renewed momentum in the housing market. • Although the Bank considers the risks around its projected inflation path to be balanced, the fact that inflation has been persistently below target means that downside risks to inflation assume increasing importance. However, the Bank must also take into consideration the risk of exacerbating already-elevated household imbalances. • Weighing these considerations, the Bank judges that the substantial monetary policy stimulus currently in place remains appropriate and today decided to maintain the target for the overnight rate at 1 per cent. With that, Tiff and I would be pleased to take your questions. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, before the House of Commons Standing Committee on Finance, Ottawa, Ontario, 29 October 2013.
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Stephen S Poloz: Opening statement before the House of Commons Standing Committee on Finance Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, before the House of Commons Standing Committee on Finance, Ottawa, Ontario, 29 October 2013. * * * Thank you for the opportunity for Tiff and me to be with you today to discuss the October Monetary Policy Report, which the Bank published last week. The Bank aims to communicate our objectives openly and effectively and to stand accountable for our actions before Canadians. One of the best ways to do this is through appearances such as this one. Allow me to spend a few minutes on the Report’s highlights. I’d like to flag some important changes introduced with this issue. • We are modifying the Report’s format and style in order to explicitly capture the uncertainty that is inherent in our outlook. The goal is to present to Canadians a reflection of the evolution of the risks to the inflation outlook that are embedded in our policy, rather than simply compare a snapshot of the current forecast with that of our previous forecast. • The picture is not always perfectly clear and so we have added new measures of ex ante, or before the fact, uncertainty to our five most critical projection variables. We have added “rule of thumb” ranges around the base-case projection for the growth of Canadian and U.S. GDP and for Canadian total CPI inflation, as well as for the current level of the output gap and the growth rate of potential output in Canada. • With this, we are reminding ourselves – and those who watch us – that economic projections are subject to considerable uncertainty and are revised over time as new economic data become available. • Our policy formulation process is more of a process of risk management rather than one of engineering. In our policy deliberations, we evaluate and assess all of the risks, both positive and negative, and use judgement to determine the balance among them. • As is customary in October, we reviewed the forecast for potential output. Due to lower-than-expected labour productivity growth in the past year, as well as the delay in the expected pickup in demand for exports and investment, the forecast for potential output growth has been revised down slightly. • Looking forward, we expect the global economy to expand modestly in 2013. However, its near-term dynamic has changed and the composition of growth is now slightly less favourable for Canada. • Uncertain global and domestic economic conditions are delaying the pickup in exports and business investment in Canada. This leaves the level of economic activity lower than the Bank had been expecting. • While household spending remains solid, and various indicators in the housing sector continue to rise, slower growth of household credit and higher mortgage interest rates point to a gradual unwinding of household imbalances. • The Bank expects that a better balance between domestic and foreign demand will be achieved over time and that growth will become more self-sustaining. But this will take longer than previously projected. • We are expecting investment growth to contribute to a rebound in the rate of labour productivity growth over the next couple of years. However, demographic factors, BIS central bankers’ speeches primarily the aging population, are expected to put a drag on the growth rate of trend labour input. This drag will largely offset the effects of rising investment. This is why we expect that the growth rate of potential output will remain fairly stable at around 2 per cent over the next three years. • Real GDP growth is projected to increase from 1.6 per cent this year to 2.3 per cent next year and 2.6 per cent in 2015. The Bank expects that the economy will return gradually to full production capacity, around the end of 2015. • Inflation in Canada has remained low in recent months. This reflects the significant slack in the economy, heightened competition in the retail sector, and some other sector-specific factors. • With larger and more persistent excess supply in the economy, both total CPI and core inflation are expected to return more gradually to 2 per cent, around the end of 2015. • Although the Bank considers the risks around its projected inflation path to be balanced, the fact that inflation has been persistently below target means that downside risks to inflation assume increasing importance. However, the Bank must also take into consideration the risk of exacerbating already-elevated household imbalances. • Weighing these factors, the Bank judges that the substantial monetary policy stimulus currently in place remains appropriate and last week decided to maintain the target for the overnight rate at 1 per cent. 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 CFA Society Winnipeg/Manitoba Chambers of Commerce, Winnipeg, Manitoba, 29 October 2013.
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Agathe Côté: The promise of potential Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the CFA Society Winnipeg/Manitoba Chambers of Commerce, Winnipeg, Manitoba, 29 October 2013. * * * Accompanying charts can be found at the end of the speech. Introduction Thank you. It is a great pleasure to be here. I want to talk today about potential, a word that speaks optimistically to the future – to what can be. It’s a word that means different things to different people under different circumstances. It’s an abstraction: a concept that promises a road leading to success. That is the finish line – the promised destination. Getting there is another story. The way forward is seldom direct and reaching potential is a trajectory where the journey is as important as the destination, especially for the “dismal” science of economics. We can think of Canada’s economic potential as where we can be if we do our best and make all the right decisions. It is what we can hope to achieve over the longer run. Since potential output growth is key to a country’s standard of living, it should be of interest to all of us. Consider this: if potential output were to grow by an extra percentage point every year for the next ten years, the cumulative increase in income would be almost $30,000 for every Canadian. At the Bank of Canada, we care about potential output for two reasons. First, the growth rate of potential output sheds light on the prospects for our country’s economic growth. Second, the difference between the level of actual and potential output – or the output gap – is a key measure of inflation pressures. And keeping inflation at the 2 per cent target rate is the best contribution that monetary policy can make to the financial well-being of Canadians. The Bank’s assessment of the current output gap and the projected growth of potential output have a direct bearing on the Bank’s inflation outlook and monetary policy decisions. Other things being equal, a larger degree of slack in the economy implies a greater need for monetary policy stimulus. As well, the higher the projected growth rate of potential output, the higher the economy can grow without stoking inflation.1 Each year in October, the Bank reviews its estimates of potential output. I will share with you some of our findings and what we think they say about the journey Canada’s economy is taking. Although Canada came out of the recession earlier and recovered faster than other G-7 countries, our economic growth has been disappointing in the past year. I think we can agree that the finish line is proving elusive; we “are not there yet.” Looking ahead, the Bank sees the economy gaining momentum through next year and 2015, but there are uncertainty and risks around the outlook. Over time, one can expect the economy to operate at its full capacity, with no output gap and with inflation steady at its target rate. At that point, the growth rate of potential determines the pace of economic activity. It is worth noting that reaching potential growth does not necessarily imply that the economy has returned to its natural or self-sustaining growth rate. Depending on the circumstances, monetary policy may still need to provide stimulus or restraint. BIS central bankers’ speeches If my speech today achieves its potential, you will gain a deeper understanding of potential output in Canada, why it is hard to measure, why it has slowed, where we are today, and what the future may hold for our economy. Deconstructing the immeasurable Measuring potential output and the output gap is difficult because potential is not directly observable. It is hard to measure what could be. What we try to do is determine the level of output that can be achieved with available resources (labour, capital and materials) without creating inflationary pressures. Potential output as a concept, and its link to inflation, make a lot of sense. Time is the most precious quantity, and as you know too well, balancing our professional and personal lives is no easy task. And as the former encroaches on the latter, history tells us that wage pressures begin to build, eventually leading to higher prices. Similarly, when a firm’s production can’t keep pace with demand, prices move up in an attempt to restore balance. But while conceptually appealing, accurately measuring potential output is a formidable task. To do so, we must take a view not only on how many hours people are willing to work at a given wage, but also on how productive these people will be when their labour is combined with other inputs, such as machinery and equipment or on-the-job training. At the aggregate level, the future trajectory of potential output will depend on a lot of variables: on how strong the demand is for our goods and services, on how much existing firms decide to invest in research and development and technology, on how many new firms are created, and other unknowns.2 It will also depend on our workforce – who is working and until what age, and whether workers can move easily to where the best jobs are and where they are most needed. In light of all these unknowns, the Bank of Canada has to use various models, indicators, as well as information gathered from businesses, and a good deal of judgment to come up with its estimates.3 Our analysis focuses on the two variables that determine actual output and whose trends determine potential output, that is, labour input (or total hours worked) and labour productivity (or real output per hour worked). The results of our most recent analyses tell us that the output gap is sizable and that the growth rate of potential is likely to remain fairly steady at around 2 per cent in coming years. But, before I go into further detail on the outlook, let me step back and describe how we got to where we are now. A tale of troughs and trends For that I have a short story and a long story. I’ll begin with the short story: the recession. As I said, Canada weathered the global financial crisis relatively well, but we were severely affected nonetheless. In the space of three quarters in 2008 and 2009, the level of output fell by 4 per cent. The export-oriented sectors (including resources) were hardest hit, with GDP dropping by 15 per cent (Chart 1). Across Canada, almost 400,000 jobs were lost. See S. Poloz, “Returning to Natural Economic Growth” (speech to the Vancouver Board of Trade, 18 September 2013). In practice, separating potential from actual output amounts to distinguishing between the underlying trend and cyclical movements in output. Different approaches can be used to extract these trends, ranging from very simple mechanical filters to structural models. BIS central bankers’ speeches The recession also led to a drop in the growth rate of potential output (Chart 2). Some businesses shut their doors. Machinery and other capital were left idle or scrapped altogether. Rather than investing in new capital, other firms made do with old equipment. These factors combined to make workers less productive. Our best judgment is that trend labour productivity growth might have fallen to less than half a per cent during that period and that potential output troughed at about 1.5 per cent. But as I said, there is also a long story. That story has two parts: trend labour productivity and trend labour input. Trend labour productivity I’ll start with trend labour productivity. From the mid-1990s to about 2000, the boom in technology production was associated with a sharp increase in the growth rate of productivity and potential output in Canada. Since then, however, productivity growth has slowed to historically low rates and has languished well below U.S. rates. While U.S. companies started using information and communication technology (ICT) capital (specifically software) to boost their processes and business practices, it appears that Canadian companies did not follow suit. Many other factors likely contributed to the slowing of productivity growth in Canada and the widening gap with the United States (Chart 3). The explanations range from measurement issues, to economic restructuring in response to large commodity price shocks, to deeper structural determinants, including a poor innovation record, low competition in some sectors and a less-skilled workforce.4 The Canada-U.S. gap may also reflect greater offshoring and foreign affiliate sales by U.S. firms. Since much of the decline in actual productivity growth in the first half of the 2000s coincided with strong overall economic growth, this suggests that a significant part was structural (and not only cyclical) and therefore affected trend labour productivity growth. Since 2008, however, part of the weak growth has been due to cyclical factors associated with the recession. It is worth noting that in spite of low productivity, Canadians have enjoyed relatively high incomes in the past several years. Our standard of living depends not only on the volume of output but also on the trading value of that output. As commodity prices rose, our terms of trade – the price we get for our exports relative to the price we pay for our imports – improved, helping to boost Canadian income growth. But going forward, productivity may become more crucial to our financial well-being, since real commodity prices, while expected to remain elevated, may not rise as much as they did in the past decade. Trend labour input Let me turn now to the second part of the story: trend labour input. The total hours worked by the labour force is a function of the working-age population, the employment rate, and average hours worked. Demographic factors are key to all of these. Until around 2008, the growth rate of the working-age population remained fairly steady (Chart 4) and the increased participation rate of women almost completely offset the declining participation rate of men. But, since then, the effects of an aging population have See M. Carney, “The Virtue of Productivity in a Wicked World” (speech to the Ottawa Economics Association, 24 March 2010); T. Macklem, “A Measure of Work” (speech to the Winnipeg Chamber of Commerce, 4 October 2012); and “Canada’s Competitive Imperative: Investing in Productivity Gains” (speech to Productivity Alberta, 1 February 2011). BIS central bankers’ speeches become more noticeable. We are getting older, living longer and having fewer children.5 Baby boomers are retiring or reducing the amount of hours they work and lower fertility rates over the past 20 years means that more people are leaving the workforce than entering it. While net immigration is important, and currently accounts for half of the population growth in Canada, it cannot stop the labour force deceleration. Other factors, besides demographics, are evidently affecting labour input, but their impact on the trend is harder to discern. For instance, the recession affected both the demand and supply of labour. On the one hand, firms cut back on hiring and hours worked diminished. On the other hand, individuals looked to work more to make up for lost wealth and income. It is unclear to what degree these two factors offset each other in terms of the trend and how persistent they are. The Bank’s estimates assume that, on balance, the recession had little impact on trend labour input growth.6 Taking stock To sum up, productivity growth was on a downward trend going into the recession and the recession exacerbated this trend. Largely as a result, the growth rate of potential output is estimated to have declined from above 3.5 per cent in the late 1990s to about 1.5 per cent in 2009. With output well below potential during the recession, the amount of excess supply grew to as much as 3.5 to 4.5 per cent. Thanks to strong domestic demand, Canada recovered fairly rapidly from the recession and registered solid growth in 2010 and 2011. As production increased and business investment accelerated, we estimate that trend labour productivity growth has slowly increased, leading to a pickup in potential output growth to about 2 per cent in the past year. While our estimates suggest that the economy was getting close to potential in late 2011, slower growth since then has led to a significant buildup of excess capacity. Taking into account a range of indicators and models, the Bank judges that the amount of slack today is between 1 and 2 per cent. Given the enormous complexity in estimating potential output, it is no surprise that the various indicators monitored by the Bank suggest a range, rather than a single point. Furthermore, distinguishing between movements in indicators that reflect cyclical demanddriven factors from those that are more structural is very tricky. Let’s take the employment-topopulation ratio as one example. This ratio has been hovering at about 0.62 for more than two years, much lower than its pre-recession peak of 0.637 (Chart 5). Taken at face value, it points to a considerable degree of slack in the labour market. But, our discussion of demographics suggests that there are other forces at play not related to cyclical labour demand. With each passing year, older workers are making up a larger share of the workforce, and these workers understandably have a much lower participation rate. If we focus instead on the employment ratio of prime-age workers, we see that a much larger proportion of the losses suffered during the recession have been recovered. Whether we should expect to get back to the pre-recession peak is also open to question, since this period marks the highest employment ratio going back several decades. The problem with using historic peaks in employment, or connecting historic peaks in GDP, is that Canada is far from unique in this situation. All G-7 countries have seen a drop in the total fertility rate and an increase in life expectancy. However, the situation in Canada is more favourable when compared with that of Germany, Italy and Japan. See J. Boivin, “Aging Gracefully: Canada’s Inevitable Demographic Shift” (speech to the Economic Club of Canada, 4 April 2012). Prolonged unemployment can lead to a loss of human capital, as workers’ skills deteriorate, making it difficult to re-enter the work force. These persistent effects could ultimately have a negative effect on potential output growth. However, it is not yet clear how large this effect will be. BIS central bankers’ speeches by definition, the economy can never be in excess demand. But, of course, history suggests otherwise. Economies can and do produce above their long-run sustainable level. Reaching our destination Looking forward, the Bank of Canada expects that excess supply will be absorbed slowly over time and that the Canadian economy will return to its full potential around the end of 2015. This outlook depends on the various forces at play that will affect demand growth in Canada, and also on how potential output growth will evolve. The Bank expects the underlying momentum in the economy to build over time. Growing foreign demand will benefit our export sector. Growth in the export sector, combined with continued moderate growth in household spending, should boost business confidence and investment – investment that will contribute to higher productivity growth. But this growth is expected to be offset by a further slowing in trend labour input, such that potential output growth remains fairly stable at about 2 per cent (with a range of ± 0.3 percentage points). The projected slowdown in the growth rate of trend labour input (from 0.8 per cent in 2013 to 0.5 per cent in 2016) is the result of the continuing demographic trends I mentioned earlier. This could change a little if older people stay in the workforce longer or increase the average number of hours they work. Whether or not they do so will depend importantly on their financial situation and whether they think they can afford to retire. For example, if 15,000 additional workers over 55 decide to stay in the labour force next year, we could expect the growth rate of trend labour input to remain stable. The growth rate of trend labour productivity is expected to continue to increase in the next few years, reaching an above-average rate of 1.4 per cent in 2015. Since the recession, we have seen strong investment in the mining, oil and gas sector (Chart 6). Given the time it takes for these investments to translate into stronger output, the continued expansion of infrastructure in this sector is expected to contribute to future productivity growth. The Bank expects to see greater investment across most sectors of the economy. Investment in machinery and equipment (M&E) and in research and development (R&D), which have been slower to recover, are expected to gain strength as foreign activity, in particular U.S. demand, accelerates. In addition to contributing directly to productivity through capital deepening (the amount of capital available per worker), investment in M&E and R&D are associated with the adoption and creation of new technologies and processes that have a further positive effect on productivity. Other factors that are expected to contribute to the recovery in the growth of trend labour productivity include Canada’s highly educated workforce, which will be able to adapt quickly to new technologies.7 As well, we expect firms to continue to adjust to the strong Canadian dollar as they adapt to highly competitive international markets. Stronger investment also means more new jobs. Already we are seeing job creation in occupations that demand relatively high skill levels in industries with above-average wages. Recent experience has shown how new technologies and industries can emerge from Although Canada has a highly educated workforce (we have one of the highest levels of tertiary degree attainment in the Organisation for Economic Co-operation and Development), we are lacking in certain key areas for productivity growth including fewer managers with university degrees and fewer university degrees granted in science, technology and business than in the United States. BIS central bankers’ speeches recessions and create new classes of jobs and a virtuous circle of improving confidence and expanding economic capacity. There are also positive signs pointing to improved labour productivity. But there is still considerable uncertainty on the road ahead, and relatively weak performance in the recent past should temper our expectations. This said, productivity could also increase at a faster pace than we currently anticipate. This could occur if, for instance, net firm creation, which has been relatively weak since 2008 rebounds at a faster pace. Canadian firms’ plans to expand exports to the fastest-growing emerging market economies and greater integration into global supply chains could also result in higher productivity growth over time. Conclusion As I said at the beginning, potential output growth is key to a country’s standard of living. In arriving at its forecast for Canadian economic growth and inflation, the Bank analyzes where economic activity could be and where it actually is. We assess how – and when – this gap is most likely to close. This analysis feeds directly into our monetary policy decisions. Our analysis suggests that low inflation in recent months mainly reflects a significant amount of slack in the economy. We expect this slack to be absorbed gradually in the next two years, such that inflation also returns gradually to 2 per cent around the end of 2015. Weighing the downside risks to inflation against the risk of exacerbating already-elevated household imbalances has led the Bank to judge that the substantial monetary policy stimulus currently in place remains appropriate and therefore to maintain the target for the overnight rate at 1 per cent. As I’ve made clear in my remarks, estimating the output gap and the speed at which potential output will grow in the future is subject to considerable uncertainty. As more data become available, the Bank will continuously review its assumptions, and the balance of risks. The analysis also offers some key takeaways about what the future may hold for our economy. While Canada’s potential output took a hit during the recession, longer-term trends have also been at work affecting both trend labour input and trend labour productivity. An unrelenting demographic shift is under way. Strength in the growth rate of trend labour input can no longer be counted on to support potential output growth in the face of poor trend labour productivity. And, while Canada benefits from abundant natural resources, one cannot necessarily count on commodity prices to provide the same boost to income growth in the future as they have in the recent past. Here in Winnipeg you have reasons for confidence, with a productive and skilled workforce, diverse industry, healthy investment in research and development, and an unemployment rate that is consistently among the lowest in Canada. Your province has the necessary tools to build productivity and prosperity. As we journey forward, the Bank of Canada will continue its efforts to understand the trends affecting Canada’s economy and sharing what we learn with business leaders like you. We will also maintain our firm commitment to keeping inflation low, predictable, and stable. While there are many variables at play, the 2 per cent inflation target is a constant at the Bank of Canada, and an essential part of our role to promote the financial and economic welfare of Canada. Thank you very much. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, presented to the Canadian Space Agency, Saint Hubert, Québec, 7 November 2013.
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Stephen S Poloz: $5 and $10 bank note issue Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, presented to the Canadian Space Agency, Saint Hubert, Québec, 7 November 2013. * * * It is a great honour for me to be here to complete the launch of the Frontiers series of bank notes. As of today, we are releasing the new $5 and $10 polymer notes, which are now ready to join the twenties, fifties and even maybe a hundred or two that have already made their way into our wallets. One of the most important functions of the Bank of Canada is to design and issue bank notes that are hard to counterfeit so that Canadians can use them with confidence. With this new, innovative series, the Bank has produced some of the most secure bank notes in the world. As Governor of the Bank, I join all my colleagues in expressing our pride in the Frontiers series. It is aptly named since each bank note pushes the frontiers of security and technological innovation to maintain low counterfeiting levels and ensure that confidence in cash remains strong. The images on the bank notes also speak to the theme of frontiers. Each tells a uniquely Canadian story. With the $100 note, the story is medical innovation, including the discovery of insulin and the invention of the pacemaker. On the $50, we evoke our far north and Arctic research. On the $20, the image of the Canadian National Vimy Memorial reminds us of the valour and sacrifice of Canadian soldiers in military conflicts throughout our history. The bank notes we are issuing today continue this tradition. The new $5 and $10 bank notes tell a story about the frontiers of our country and even our universe. The $5 note highlights Canada’s technological achievements that look skyward – our contributions in robotics to the International Space Station Program. The $10 note depicts a great feat of engineering from Canada’s past – the joining of east and west by rail. This is where the bank note story gets personal for me. I grew up hearing about George Stephen, whom I am named after. He was president of what was then the new railway company, and was the principal financier of the building of CP rail. By all accounts he was a man who shunned the limelight and who said about himself that he had neither the training nor the talents to accomplish anything without hard work. Well, without his hard work, we may not have had the Canadian Pacific Railway. The building of the CPR was years in the making and involved the hard work and sacrifices of thousands. It was a monumental undertaking – a feat of engineering and nation building. Our speakers today have reminded us that our bank notes reflect the people and the society where they are used. Canada is a world leader in using innovation for secure bank notes. Work on this series started eight years ago, in 2005. It’s not that we work slowly at the Bank of Canada – that’s how long it takes to reach new frontiers in bank notes using a new polymer material and state-of-the-art security features. Well over 700 million are now in circulation. With this series, the Bank sets a global benchmark for currency. It’s a big change and we are working closely with the cash handling industry, including financial institutions and retail associations to finalize the transition from paper to polymer and make sure it is a smooth one. And though we are very proud of these bank notes, we are not standing still. BIS central bankers’ speeches That’s because neither technology nor counterfeiting stands still. You can be sure that at the Bank of Canada we will continue to innovate and apply new technologies so that we stay ahead of the counterfeiters. BIS central bankers’ speeches
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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the Vancouver Train Station, Vancouver, British Columbia, 7 November 2013.
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Tiff Macklem: $5 and $10 bank note issue Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the Vancouver Train Station, Vancouver, British Columbia, 7 November 2013. * * * Good morning friends and colleagues and welcome to this event to launch the new $5 and $10 polymer notes. I am very pleased to be here in beautiful Vancouver, representing the Bank of Canada. And like the Governor, I am proud of these bank notes. They are making history: a first for Canada and, indeed, the world. With these notes, Canada breaks new ground. They are safer, cheaper, and greener. Safer, because all the notes have the same state-of-the-art security features, using holography, transparency and other elements that make them very difficult to counterfeit but easy for everyone, especially those behind the counter, to verify. We are the first – and for now, the only country – to have a hologram within a transparent window on our bank notes. Cheaper, because they last longer than paper notes. This means fewer notes will need to be printed and transported, making the series more economical. Greener, because over the life of the series, fewer notes will be produced. And when they do wear out, they will be recycled. It’s possible that they’ll be recycled into new products – products, such as this flowerpot. Those are some facts about the new notes. But let me put to rest a few urban myths that have been making the rounds about the polymer notes. My favourite myth is that the notes smell like maple syrup. They don’t. So if you get a new bank note and it doesn’t smell of maple syrup, don’t worry. That’s a good thing. And you can rest assured; there is no chance these notes will melt if you put them on the dashboard of your car. Trust me on this. There is a chance, however, that your car might be broken into, so I don’t recommend it. Starting today, these safer, cheaper, greener, bank notes will be rolled out across Canada; and over time, they will make it into everyone’s hands. Given the striking imagery on the $10 bank note, it is entirely appropriate that we are here on National Railway Day. This day marks the anniversary of the hammering of the last spike into the railbed in Craigellachie, British Columbia. That act, 128 years ago today, concluded the construction of the railway system upon which Canada was built. We are very lucky to have the last spike with us here today. Well, sort of the last spike. Every spike has a story. In actual fact, there were three spikes. The first was damaged when it was hammered in, so it was removed and turned into jewellery. The second “last” spike was removed shortly after it was driven in to make sure that no souvenir hunters grabbed it. It was eventually transformed into a carving knife. The spike we have here today truly is the “last” spike, in that it’s the one that has lasted. It was supposed to be driven in by the Governor General of the time, Lord Lansdowne. An unforeseen glitch that Canadians throughout history can relate to – a snowstorm – prevented Lord Lansdowne from attending the ceremony, so he mounted the spike and sent it to Sir William Van Horne, the CPR executive who led the project. But to tell us more about Canada’s railway, I would like to ask Marc Laliberté, President and CEO of VIA Rail, to come to the podium. BIS central bankers’ speeches
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Federal Reserve Bank of San Francisco, San Francisco, California, 5 November 2013.
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John Murray: Transitioning to more balanced and sustainable growth Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Federal Reserve Bank of San Francisco, San Francisco, California, 5 November 2013. * * * Introduction Canada shares many similarities with emerging market economies (EMEs) in Asia. Indeed, in some respects, we wish we were even more like them – particularly in regard to growth. Like most Asian countries, Canada has a very open economy that is heavily influenced by developments elsewhere, especially those in its southern neighbour. Despite Canada’s sound financial system and solid fiscal position, it was seriously affected by the financial crisis and suffered proportionately almost as much as the U.S. economy did over the 2008–09 period, owing to its strong economic and financial links to the United States (Chart 1). Chart 1 Canada’s economy was seriously affected by the crisis but has recovered Although economic activity in Canada has now fully recovered, and moved well beyond its pre-crisis peak, our economy is in the midst of a difficult rebalancing process and has yet to achieve self-sustaining growth unassisted by exceptionally accommodative monetary policy. Unlike most Asian economies, Canada hopes to shift away from the excessive domestic demand that it was forced to rely on when its export sector collapsed, and to draw increasing support from external demand (Chart 2). Unlike many advanced economies and EMEs that suffered from serious excesses before the crisis, in Canada’s case, this re-equilibration should involve a return to the sort of balanced state that it enjoyed immediately prior to 2007. There are other important ways in which Canada differs from some of its Asian trading partners. Over most of the post-World War II period, we have operated under a system of BIS central bankers’ speeches freely flexible exchange rates, absent any currency or capital controls. While we are exposed to many of the same external shocks experienced by other open economies, we have always believed that it is better to work with markets rather than against them, allowing the price system to operate. Yet “playing by the rules” has sometimes proven difficult, owing to the contagion created by those who are not. Nevertheless, in the long run, our flexible approach has served us well. Chart 2 Canada must reduce its reliance on domestic demand Asia’s phenomenal but increasingly unbalanced growth Over the past 13 years, the Asia region has experienced phenomenal economic growth, moving from a 7 per cent share of global economic activity as recently as 2000 (measured at market prices) to an estimated share of close to 18 per cent as of 2013. Measured in terms of purchasing power parity, the latest number would be even more impressive. The process has had some occasional set-backs, of course, and is not without precedent – I am thinking here of the late 19th and early 20th centuries and the emergence of the United Kingdom and the United States. But such growth is nevertheless extraordinary. Emerging Asia has accounted for more than 40 per cent of the world’s growth over the past 10 years, and hundreds of millions of people have been lifted out of extreme poverty. Like most episodes of successful development in the post-war period, the Asian miracle has been driven by export-led growth. In many cases this was supported by a fixed exchange rate regime, and an extensive system of currency and capital controls designed to achieve and preserve international competitiveness. Of course, there has been considerable variation across countries with regard to their economic circumstances, institutional arrangements and development strategies. The simple picture painted above does not apply to all. Nor are Asian countries the only ones in the global economy to enjoy sustained external surpluses. More importantly, for every trade surplus, there must be an equal and offsetting deficit, with many advanced countries eager in the past to play this role. BIS central bankers’ speeches Such imbalances are not unusual, but the extent to which capital was “flowing uphill” during the pre-crisis period was. This was clearly unsustainable. It is one thing for relatively small countries to play this game, but when they grow too large, they soon run out of space. Foreign reserve accumulation among the EMEs since 2000 has totalled more than US$6 trillion (Chart 3). Chart 3 The Asian miracle has generated large surpluses and large reserve accumulations The crisis as a catalyst for change When the crisis hit, export markets for the emerging Asian economies suddenly imploded. Fortunately, many of them had the fiscal and monetary policy space to cushion the blow. However, the crisis merely brought forward a process of global rebalancing that was inevitable. Advanced economies had exhausted their credit lines, and EMEs were running out of foreign customers. Advanced economies were going to have to boost domestic savings to get out of hock, and EMEs were going to have to rely on their own consumers for future growth. The coordinated and ambitious economic recovery plan that G-20 Leaders outlined in the early days of the crisis, the G-20 Framework, was designed to deliver strong, sustainable and balanced growth. It had four critical and mutually reinforcing parts: (1) meaningful fiscal consolidation in overly indebted countries; (2) sweeping financial sector reform; (3) wideranging structural reforms to boost future growth prospects; and (4) a necessary rebalancing of global demand between deficit and surplus countries, assisted by more flexible, marketdetermined, exchange rates. The first three parts of the plan would inevitably have contractionary effects in the short run, so a domestic-led expansion of demand in surplus countries was a critical component of the G-20 plan if global deflation was to be avoided. Any positive confidence effects that might be associated with promises of fiscal rectitude and substantive structural reform were likely to be small and insufficient, on their own, to correct the widening output gap. BIS central bankers’ speeches So how have we done? It is safe to say that global economic performance over the past five years has been disappointing. As acknowledged in various G-20 communiqués, growth has been neither strong, nor sustainable nor balanced. Shortly after the crisis and the announcement of the G-20 Framework, economists at the Bank of Canada decided to use their global model to examine three very different scenarios for how the global economy might unfold. The first was the so-called “good” scenario, where every player did what it had promised and all four parts of the plan were delivered. It is important to stress, however, that this was not a Goldilocks scenario by any means, just something that, in a rough and ready way, would satisfy the requirements of the G-20 Framework. The second scenario was a “bad” one, in which no one initially did what they were supposed to. But it assumed that eventually everyone would come around, after a substantial lag, and do the right thing. Without this assumption the model and, presumably, the global economy, would explode. The third scenario was actually worse than the bad one, at least for the first few years of the simulation, and our economists called it the “ugly” scenario. It involved doing only half the job. More specifically, only the first three parts of the G-20 Framework, which were inherently deflationary, were set in motion. The estimated cumulative costs to the global economy from following the bad scenario over 2012–16, as opposed to the good one, were US$16 trillion or 5.4 per cent of global GDP (Chart 4). The estimated cumulative cost for the ugly scenario was even larger, at about US$18 trillion or 5.8 per cent of global GDP. Chart 4 The “Good”, the “Bad” and the “Ugly” scenarios So where is the real world economy now? Our best estimates suggest that we are sitting somewhere between the good and the bad scenarios but, in truth, a little closer to the bad. Performance with regard to the four key elements of the G-20 Framework has been mixed. Significant progress has been made on financial sector reform and fiscal consolidation, with sometimes too much of the latter, but much less has been accomplished on structural reform and global rebalancing. Had it not been for the support provided by exceptional monetary stimulus, the outcome would have been much worse, somewhere between the bad and the ugly scenarios. However, this situation cannot be sustained. Monetary policy provides only a temporary bridge; it cannot act as a substitute for more fundamental reform and economic adjustment. BIS central bankers’ speeches Hopeful signs on the horizon Happily, there are positive signs on the horizon. The advanced economies seem to be getting their act together. The pre-conditions for a return to stronger growth are present in the United States. Europe has emerged from a six-quarter recession and is progressing, albeit slowly, with its reforms. Japan has successfully launched the first stage of its “Three Arrows” program. Growth has recently faltered in some EMEs in response to past policy tightening, accumulated supply bottlenecks, and financial market turbulence. However, China appears to have stabilized its economy at a sustainable and solid growth rate of approximately 7.5 per cent (conveniently consistent with its target growth rate). More importantly perhaps, China and several other Asian countries appear to be liberalizing their economies, allowing more flexibility in prices and exchange rates, and otherwise assisting the adjustment process (Chart 5). Chart 5 Asian EMEs are showing more flexibility in their exchange rates There is a risk, however, that the recent jump in financial market volatility in anticipation of tapering by the United States will tempt some countries to impose additional currency and capital controls and to intervene more aggressively. Indeed, there is new-found sympathy for these tools in the international community, at least when they’re applied in a temporary and targeted manner as a form of international macro-prudential stabilization. It is important, however, that nothing that is done as a possible short-term palliative be allowed to interrupt the rebalancing and necessary process of normalization that is underway in the global economy. Some may use this more forgiving attitude as cover to continue earlier unhelpful practices, but this would only invite a replay of past unpleasant events. Exiting from the extraordinary policies that were put in place by several advanced economies to buttress growth is going to be challenging. As many observers have noted, “We are travelling in uncharted territory.” But at least the incentives of the countries that are exiting – and those on the receiving end – should be well aligned. No one should want advanced economies to exit too early or too late, and no one benefits from excessive market turbulence. Some episodes of increased volatility will no doubt be experienced, but advanced BIS central bankers’ speeches economies are committed to being as transparent as possible in order to minimize surprises and smooth the adjustment process. It is important that countries play by the rules and stand by the commitments that many of them made as part of the G-20 Framework. Displaced pressures from exchange rates that are not allowed to move, from capital flows that are directed elsewhere, and from outsized reserves that are looking for a safe home often squeeze small open economies such as Canada’s and, more critically, frustrate the international adjustment process. BIS central bankers’ speeches
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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to Autorité des marchés financiers, Montreal, Quebec, 18 November 2013.
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Tiff Macklem: Management and financial reform Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to Autorité des marchés financiers, Montreal, Quebec, 18 November 2013. * * * Introduction Good morning and thank you for the invitation. It is a pleasure to be here in Montréal, where I was born and raised. Sound risk management in Canada by both the private and the public sectors played a definitive role in steering us through the financial crisis. As you well know, none of our banks failed and none had to be rescued. And importantly, our financial system continued to function. So when the Bank of Canada injected exceptional liquidity and monetary stimulus, and the federal and provincial governments undertook extraordinary fiscal stimulus, credit flowed to households and businesses and they responded. As a result, we had the shortest recession and the fastest recovery in the G-7. But I am not here to boast. Lest we forget, we had our own risk-management failures here in Canada. I am sure I don’t need to remind you that our non-bank asset-backed commercial paper market froze in the summer of 2007, at the onset of the crisis. And the crisis reminded us that keeping our own house in order is not enough. Even if our financial system proved resilient, our exports plummeted 21 per cent in the wake of the global recession. And still today, our exports remain below their pre-recession level. The global financial crisis continues to cast a long shadow. This underscores the importance of completing the global financial reforms that were launched exactly five years ago this week at the first G-20 Leaders Summit. Convened by President George W. Bush following the Lehman failure, it was held in Washington on the 14th and 15th of November in 2008. At the Summit, the Leaders agreed on a set of common principles for the reform of the global financial system. And five months later, at the London Summit in April 2009, the Leaders elaborated on those principles by committing to a sweeping and comprehensive reform agenda. Their fundamental objective was to build a resilient global financial system that would serve households and businesses in good times and in bad. To do this, the Leaders created the Financial Stability Board (FSB), and gave it four core tasks: • make banks safer; • end “too big to fail”; • mitigate bank-like risks in the shadow banking sector; and • ensure continuously functioning core financial markets. Since the London Summit, a great deal has been accomplished. And the financial system is much safer as a result. But there are still some important elements that remain to be completed, and we need to get these across the finish line. Today, I want to quickly review the highlights of what has been achieved and then turn to four areas that need further work: leverage limits; bail-inable securities; core funding markets; and finally, risk disclosure, governance and culture. BIS central bankers’ speeches In a nutshell, my message is that while the roots of this crisis were in complex instruments and interactions, the foundational elements for a more resilient financial system are not complex: bigger capital and liquidity buffers combined with a leverage backstop, rigorous and proactive supervision, and robust financial system plumbing. But risk is complex. Completing the reforms and then ensuring ongoing healthy vigilance requires investments in risk management by both the private sector and the public sector. Risk management is hard work. It can't be replaced by simplistic rules. There are no shortcuts. And risk does not take holidays – it only hides. The completion of the ambitious reforms laid out five years ago is within reach. This is essential to a return to sustainable, natural growth in the global economy. Let's get it done. What’s been achieved To make banks safer, reform started by strengthening the bank capital regime. Under the new Basel III rules, the minimum capital requirement is being raised, the capital requirements for riskier activities are being increased and the definition of capital is being strengthened. All in, the largest banks will have to hold at least seven times as much high-quality capital as they did before the crisis. While Basel III calls for these changes to be implemented over the next six years, banks are not waiting to rebuild confidence in their creditworthiness. Since the end of 2007, major banks in the United States and Europe have increased their common equity capital by $615 billion and their common equity capital ratios by almost 30 per cent. National legislation has now been adopted to implement the Basel III capital framework in virtually all G-20 jurisdictions. Canada was one of the first jurisdictions to implement it. By the beginning of this year, all major Canadian banks had met the stringent Basel III requirements – six years ahead of the generous deadline of January 1st, 2019. To end the problem of “too big to fail,” a three-pronged approach has been agreed upon. First, banks whose failure would pose a risk to the global financial system will face a capital surcharge. This framework has also been extended to domestic banks. Here in Canada, our six largest banks have been designated as domestic systemically important banks by the Office of the Superintendent of Financial Institutions. And in Quebec, the Autorité des marchés financiers has designated Desjardins as a domestic systemically important financial institution. All seven are required to hold 1 per cent more capital. Second, standards, known as the “Key Attributes,” have been established for the effective resolution of financial institutions. Under the Key Attributes, bondholders, shareholders and management – rather than taxpayers – will have to bear the brunt of losses. Third, systemically important institutions are facing more intense and more effective supervisory oversight. This includes recovery and resolution plans, a cross-border cooperation agreement between relevant authorities, and a resolvability assessment. Work is also well advanced to extend this framework to other systemic financial firms, including global insurance companies, non-banks and core financial market infrastructure. On shadow banking, the goal is to transform it from a source of vulnerability to a source of market-based finance that adds competition, diversity and resilience to the financial system. Here, too, we have made good progress. At the most recent G-20 Summit in St. Petersburg this past September, the Leaders endorsed a set of recommendations to increase transparency, reduce moral hazard, and limit maturity and liquidity transformation. Finally, on strengthening the resilience of core financial markets, more than half of the FSB’s member jurisdictions now have legislative frameworks in place to ensure that derivatives BIS central bankers’ speeches transactions are reported to trade repositories; that standardized over-the-counter (OTC) derivatives are cleared through central counterparties; and that non-centrally-cleared derivatives have higher capital and margin requirements. There is more, but I want to turn to the four issues that deserve particular attention. Leverage limits In an ideal world, regulators would accurately measure the riskiness of bank assets when setting capital requirements. But risks, of course, are not known with certainty nor can they be measured with precision. As a complement to the risk-based capital framework, a simple, but effective, leverage ratio was therefore imported from Canada into the global standard. This leverage ratio sets a cap on the value of the assets a bank can hold for each dollar of equity. It protects the system from risks that we might think are low but in fact are not. We are big fans of a leverage limit here in Canada. We had one going into the crisis, and it served us well. But as the leverage ratio is finalized by the Basel Committee on Banking Supervision over the course of next year, it will be important to get its calibration right. The belt and suspenders approach of the new capital standards and leverage ratios establishes two tests for the maximum amount of assets that financial institutions may hold relative to equity. At issue is which of these should typically bind first. The leverage ratio was initially conceived as a backstop. Risk-weighted assets would normally be the binding constraint. The role of the leverage ratio is a simple, fail-safe second line of defence. Some, however, are arguing that the Basel III capital framework is too complex and are reluctant to put their faith in risk-weighted assets. They point to recent studies by the Basel Committee that show significant variations in risk weights applied by banks across jurisdictions for similar portfolios of assets. They argue that the simpler leverage ratio should be calibrated as the binding constraint. While this appeal to simplicity may be ostensibly attractive, it is likely to have a perverse effect. If the leverage ratio normally binds, the incentives for banks to manage their risks will diminish. Banks will load up on riskier assets and push other assets off their balance sheets. The result will be more risk, not less. We need to embrace risk management, not avoid it. In practice, this means three things. First, the industry has to invest in risk assessment and analysis, including robust financial modelling. Second, supervisors need to invest in strong oversight of all elements of good risk management, including the risk culture and risk-governance framework. Third, there is work to be done at the Basel Committee and on the ground to improve the consistency of risk-weighted assets across jurisdictions. With a determined investment in risk management, this is achievable. Bail-inable securities The higher capital standards in Basel III, combined with a well-designed leverage ratio and appropriate liquidity requirements, will substantially reduce the probability of failure, but since failures will still happen, we must also reduce their impact. Bail-inable securities are part of the solution. BIS central bankers’ speeches A bail-in regime can help authorities maintain critical banking operations by returning to viability institutions that are perceived as being too big to fail. Bail-in debt will give the authorities the power to recapitalize a failed bank by rapidly converting certain bank liabilities into regulatory capital. This reduces the risk that the burden will fall on taxpayers, and helps to eliminate any unfair advantage that institutions might enjoy from the markets’ belief that they are too big to fail. The FSB is currently developing an international approach on the adequacy of lossabsorption capacity in bank resolution. In the March 2013 budget, the Canadian government announced its intention to institute a bail-in regime for systemically important banks. Canadian authorities are considering the appropriate amount and nature of loss absorbency required for Canadian institutions. Public consultations will take place on how best to implement the regime, and implementation timelines will allow for a smooth transition for affected institutions, investors, and other market participants. We will need the help of the private sector to design marketable financial contracts that can be bailed-in to resolve a major bank. Continuously functioning core funding markets Let me now turn to financial market infrastructure. For the financial system, ensuring that core funding markets are continuously open in times of stress is essential to managing liquidity risk. In Canada, a central counterparty (CCP) service to centrally clear repo transactions was launched last year by the Canadian Derivatives Clearing Corporation (CDCC), which is based here in Montréal. The repo market is a major source of funds for financial institutions. By becoming the counterparty to all trades, a CCP minimizes counterparty credit risk and mutualizes losses. CCPs also promote robust risk-management practices and default-management mechanisms. For financial institutions subject to regulatory capital and leverage requirements, CCPs improve balance sheet netting, which, in turn, should benefit other users through deeper and more liquid markets and better pricing. The CDCC worked closely with the Investment Industry Association of Canada, stakeholders in the financial industry, the Bank of Canada and other regulatory authorities to create this new CCP, which began operating on a modest scale in February 2012. A second phase of the CCP for repos was launched in December of 2012. It added the possibility for members to trade and clear “blind” repos. Since then, the clearing of cash trades has been added. And very recently, provincial securities have been included as well. To increase the new CCP’s share of overall repo activity, the CDCC and the industry have engaged in discussions with “buy-side participants” that are significant players in the Canadian repo market. Having these market participants join the repo CCP is important because it will enhance the resilience of this core funding market in times of stress. This is important to the Bank of Canada. In addition, greater participation would reinforce the overall benefits of the CCP since more members would generate higher clearing volumes, more market liquidity, broader ability to conduct term transactions and deeper netting opportunities. The reality is that Canada is ahead of the world in this initiative. It is tough being in the lead, but we have done it before. We have an opportunity here to create a CCP model for others to follow. We are making good progress. Let’s keep the focus. BIS central bankers’ speeches Risk disclosure, governance and culture I know I have already asked for a lot from the private sector, but before I wrap up, I want to speak more directly to the private sector’s responsibilities. First, risk disclosure. Supervisors work with banks to assess riskiness. But it is equally important that markets have adequate information so that analysts can better evaluate risk themselves. That is why I welcome the report that the Enhanced Disclosure Task Force published last autumn.1 This private sector effort, the result of a unique collaboration between users and preparers of financial reports, recommends that banks improve their disclosure of business models, key risks and risk-measurement practices. I strongly support OSFI in encouraging banks to implement these recommendations. Second, risk governance. A peer review of risk management undertaken by FSB members and published earlier this year found that the private sector has been addressing the gaps in risk governance that came into glaring focus during the crisis. Increasingly, firms are: • assessing the collective skills and qualifications of their boards of directors as well as board effectiveness; • instituting stand-alone risk committees that are composed only of independent directors and operate with a clear definition of independence; • establishing a group-wide chief risk officer (CRO) and risk-management function that is independent from revenue-generating responsibilities; and • integrating the discussions among the risk and audit committees through joint meetings or cross-membership. The report also made a number of recommendations to strengthen risk-governance practices, including: • improving the skill sets of individuals appointed to boards of directors; • holding board members accountable for oversight of risk governance; • elevating the stature, authority and independence of the CRO; and • obtaining an independent assessment of the risk-governance framework on an annual basis. Third, and finally, the internal culture in financial institutions is critical. In the run-up to the crisis, banking became too much about banks connecting with other banks. Clients were replaced by counterparties, and anything that made good money and was legal was a good idea. Sadly, even some things that were not legal were considered a good idea. The focus needs to return to serving clients to support the real economy. For companies, responsibility begins with their boards and senior management. They need to clearly define the purpose of their organizations and promote a culture of ethical business practices throughout. Conclusion The role of the financial sector is to channel savings to productive investment, and to help households and businesses manage the risks they face. As long as there is leverage, maturity and liquidity transformation, and credit intermediation, there will be risk. Managing risk is at the heart of financial services. Sound risk management is also essential to the public good of financial stability. Enhanced Disclosure Task Force. 2012. Report: “Enhancing the Risk Disclosures of Banks” 29 October. BIS central bankers’ speeches A great deal has been accomplished to improve the resilience of the financial system since the first G-20 Leaders Summit in Washington five years ago. But as the urgency of the crisis begins to fade in our collective memories, there is a risk that countries and institutions will stray from the common sense of purpose and determination that inspired the sweeping G-20 reform agenda. I have highlighted several areas where there is more work to be done by both the public and private sectors to complete the G-20 financial reforms. This is within reach. Let’s get it done. Finally, let me draw a link to monetary policy. Risk management is also an important element in monetary policy. In our policy deliberations, we evaluate and assess the most important risks, both positive and negative, and strive to balance them. The substantial progress achieved in implementing the G-20 financial reforms has made the global financial system safer. This has reduced the tail risk that a financial collapse somewhere in the world will affect the global and Canadian economies. Correspondingly, this risk is now weighing less on our monetary policy decisions. For me, at least, that’s one measure of progress. Thank you. BIS central bankers’ speeches
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, at Mount Allison University, Sackville, New Brunswick, 19 November 2013.
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John Murray: Price puzzles and the exchange rate Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, at Mount Allison University, Sackville, New Brunswick, 19 November 2013. * * * Accompanying charts can be found at the end of the speech. Thank you for having me here today. I expect that in New Brunswick you are well aware that there are large and persistent gaps between the prices charged in the United States and in Canada for similar goods. Many Canadians feel the same way. We can’t blame Canadian consumers for being both puzzled and annoyed. Isn’t free trade supposed to close this price gap? Shouldn’t competitive market forces cause domestic and foreign prices to converge? And if prices can’t move, shouldn’t our flexible exchange rate adjust to offset any differences? And, finally, if neither prices nor the exchange rate are moving to close these gaps, is something wrong with the system? These are good questions, and they deserve good answers. In my speech today, I’ll try to provide them. But I face two challenges. First, there is a great deal that remains to be learned, so I won’t be able to provide complete and conclusive answers. Second, I don’t have enough time to adequately review everything that has been learned, so I’ll have to hit the highlights. Let’s first get a sense of what we’re dealing with. How egregiously is the law of one price being violated? Let’s start with what things would look like in a perfect world. In a fully competitive world, free of impediments to trade, one would expect to see what we economists call the law of one price (LOP) enforced. Cross-border arbitrage would ensure that the prices of identical goods sold at home and abroad, and expressed in a common currency, were the same. To what extent has this “law” been observed? Chart 1 shows two different measures of the price gaps between Canada and the United States. The first compares the cost of living in the two countries over the past 30 years. This is a less-stringent condition than the LOP, since it doesn’t test whether the same price is observed in Canada and the United States on each and every good, but rather whether the general level of prices in the two countries is the same. To do this, it compares the cost of a similar basket of consumer goods and services north and south of the border. If the levels of the aggregate consumer price indexes (CPIs) were found to be the same, adjusted for the US$/Can$ exchange rate, the blue shaded area in Chart 1 would collapse to a single flat line and lie on the zero axis.1 In other words, the purchasing power of the Canadian dollar in each country would have been equalized. For this reason, the relationship is often referred to as the purchasing-power-parity (PPP) condition. The price gap – or the shaded blue area – in Chart 1 is defined as the ratio of Canadian to U.S. CPI (the U.S. CPI converted to Canadian dollars) benchmarked to 2007 using the Bank’s Internet survey. BIS central bankers’ speeches The second measure in Chart 1, shown as a series of black Xs, reflects data that the Bank of Canada has been tracking since 2002. It compares the posted prices on the Internet of roughly 150 different goods in Canada and the United States.2 Although differences exist between the two measures, the picture that emerges in both cases is similar, and seemingly incriminating. The lines are not where they are supposed to be and the deviations from PPP are, as suggested earlier, large and persistent. Two important points are worth noting here. First, for much of the past 30 years, prices in Canada have actually been significantly lower than those in the United States. This isn’t to say that each and every price in Canada was lower over most of the sample period. Obviously, there is considerable variation among goods and services, but, in aggregate, prices were often much lower in Canada. Things have changed over the past 10 years, however. The second point to note in Chart 1 is that the price gaps appear to be highly correlated with the level of the U.S.-Canada exchange rate (the red line). Indeed, while we might expect the exchange rate to act as a buffer, it seems to be driving prices in the two countries away from each other. This raises several questions. • Why does the exchange rate seem to be exacerbating price differences rather than offsetting them? • Shouldn’t the Canadian dollar depreciate if Canadian prices are generally higher than foreign prices, and appreciate if they are lower? • Shouldn’t the exchange rate be preserving competitiveness and correcting any trade imbalances that might arise if large deviations were allowed to persist? In short, the question is: has the exchange rate been misbehaving? Has the exchange rate been misbehaving? The answer? It’s complicated. First, many of the goods and services included in the price indexes are not traded (e.g., haircuts), so one would not expect their prices to be the same between countries. Second, there are many real-world frictions that prevent goods from trading freely. Transportation costs and other expenses related to the distribution and marketing of goods, once they arrive onshore, are often significant (especially in a country the size of Canada). These expenses can drive a substantial wedge between domestic and foreign prices. In addition, sizable trade barriers associated with tariffs and quotas do still exist, despite a general trend towards freer trade in the global economy. Finally, markets for certain goods are often less than perfectly competitive. Although the frictions that I have just listed are important, and can explain why large level differences frequently exist between domestic and foreign prices, shouldn’t exchange rates at least move in the right direction in response to any shift in prices? Shouldn’t we expect changes in the exchange rate to offset changes in prices, thereby limiting any further widening in the price gap and preserving a form of relative PPP? So what is going on? The main answer is that the exchange rate is driven by many forces other than differences in the overall level of domestic and foreign prices. If these broad price discrepancies were the Although individual surveys compare prices for identical products in Canada and the United States, a shortcoming of this approach is that it is not possible to track the exact same products over time. Therefore, the size and composition of the sample tends to vary across surveys. BIS central bankers’ speeches only thing that mattered, the real exchange rate would be a flat line. In other words, the nominal exchange rate, adjusted for prices, would be constant. This is clearly not the case, however, as shown in Chart 2. The blue line is the nominal exchange rate that we actually observe in the market. The red line is the real exchange rate, which adjusts the nominal rate for differences in domestic and foreign prices. As you can see, most of the movements observed in the exchange rate are real rather than nominal. Although some of these movements are caused by temporary – and occasionally, speculative – forces, research at the Bank has shown that most of the broad trends in Canada’s exchange rate are tied to other fundamental determinants that can’t and shouldn’t be suppressed. What are these determinants? It is impossible to identify all of them, but three in particular stand out: (i) changes in Canada’s terms of trade driven by changes in the relative price of energy; (ii) changes in the terms of trade driven by changes in the relative price of non-energy commodities; and (iii) changes in the Canada-U.S. interest rate differential. Results from a simple estimated model, which includes these three series as explanatory variables, are shown in Chart 3.3 But this begs another question. If movements in the real exchange rate are responsible for the price gaps reported in Chart 1, why don’t officials simply intervene to stabilize the value of the real exchange rate and push Canadian and U.S. prices into proper alignment? The short answer is: it wouldn’t work. These movements are driven by fundamental forces of demand and supply that can’t be suppressed forever. They will simply re-emerge. As an example, let’s say that domestic prices were seen to be higher than foreign prices. One way of fixing this would be to lower the exchange rate (i.e., cause it to depreciate). This could be done by lowering interest rates and easing monetary policy. However, if this pushed the economy beyond its capacity limits and created excess demand, it would simply generate domestic inflation. What would happen then? Canadian prices would rise faster than foreign prices. We would be chasing our tail. The same would be true with the directions reversed – that is, if we tried to correct a negative price gap by raising the exchange rate. The real exchange rate ultimately reasserts itself and moves to the level that is consistent with all the fundamentals that are at play. Does this mean that exchange rates and aggregate prices bear no relationship to one another? Does it undercut the arguments in favour of a flexible exchange rate regime? Macroeconomic evidence of long-run PPP and exchange rate past-through The short answer is no. There is evidence that, over time, exchange rates tend to move in a manner consistent with PPP. Moreover, it is a two-way street. Prices at home and abroad are affected by movements in the exchange rate – a process referred to as exchange rate passthrough (ERPT). In other words, prices affect exchange rates and exchange rates affect I. Ramzi, R. Lafrance and J. Murray, “The Turning Black Tide: Energy Prices and the Canadian Dollar,” Canadian Journal of Economics 41, 3 (2008): 737–59. BIS central bankers’ speeches prices. These variables are not only connected, but more importantly, they move in the desired direction. At times, however, it is not easy to observe them. Most of the early empirical work in this area looked at broad macroeconomic variables for evidence of PPP and ERPT. For the ERPT tests, this typically involved running simple reduced-form equations. A price index, such as the CPI, or a broad measure of import prices (denominated in the currency of the importer), would be put on the left-hand side of the equation, as a dependent variable, with the exchange rate and other control variables on the right-hand side, as explanatory variables. Using this formula, researchers expected to observe a coefficient on the exchange rate somewhere between zero and 1. A value of 1 would represent complete pass-through, while a value of zero would indicate no pass-through. Since the conditions necessary for complete pass-through, such as perfect competition and the absence of any trade barriers or other economic frictions, were unlikely to be satisfied, something between these two extremes was anticipated. In practice, researchers found that, for most countries, the pass-through coefficient was extremely small. This was especially true in the short run, since prices take time to adjust. Imported products, and the domestic goods and services that compete with them, were usually found to be more sensitive to exchange rate movements. For this reason, one would expect to see a stronger relationship when looking at import prices alone as opposed to the entire CPI. Even here, however, the evidence was often relatively weak. There are a number of possible explanations for this. First, the estimated coefficients were likely biased towards zero because of econometric problems that arise whenever one uses a simple reduced-form equation to estimate a relationship that is inherently endogenous. Since prices and the exchange rate are believed to influence each other’s behaviour, an obvious simultaneity bias exists. Second, it is also possible that effective countercyclical monetary policy and the adoption of an explicit inflation target in countries such as Canada have made it harder to observe ERPT. Some researchers have argued that a credible inflation target makes prices less sensitive to exchange rate movements in the short run because producers are reluctant to adjust prices unless they are sure the exchange rate changes are going to persist. Efforts to identify and quantify the effects of ERPT in Canada have faced an additional challenge, however, one that is beyond the countercyclical influence of monetary policy. Until recently, the absence of a reliable data series for most import prices meant that researchers had to use the CPI to test for ERPT. But, as already noted, the pass-through effects onto the CPI are likely to be quite muted. Although evidence could be found of near-complete pass-through of exchange rate changes into the prices of homogeneous and widely traded goods such as oil and other primary commodities, evidence for highly differentiated manufactured goods and speciality products was hard to find. Another result common to many macro studies was a noticeable declining trend in ERPT over time. The increasing adoption of inflation-targeting frameworks by both advanced and emerging-market economies may explain this phenomenon, along with the growing importance of differentiated manufacturing goods relative to raw materials in global trade. Several other explanations have also been put forward for weak and declining estimates of ERPT, but unfortunately there isn’t time to discuss them here. The bottom line, in any event, is that, although the estimated macroeconomic effects might not appear to be very large, exchange rate pass-through does exist and is operating in a predictable, helpful, way. BIS central bankers’ speeches More convincing microeconomic evidence of ERPT Happily, much stronger and more convincing results have recently become available by taking a micro approach. Researchers using rich micro databases have been able to analyze detailed information on individual commercial transactions and can now test for ERPT at the level of individual firms and products. This micro approach means researchers can overcome the problems associated with endogeneity and heterogeneity in the earlier macro studies. Bringing it down to the level of the firm and specific transactions provides a clearer picture and allows a more sensible pattern to emerge. Several such studies have recently been completed by my colleagues at the Bank, and others are in progress. What I would like to do in this, the concluding section of my talk, is give you a quick overview of some key results from two of these studies. The first study uses data from the Canadian Border Services Agency on every single shipment of apparel imported into Canada between July 2002 and August 2008 – more than 6.5 million transactions.4 Early results from this study show that the degree of pass-through depends importantly on two things: the currency in which the imports are invoiced, and whether the goods are shipped directly from the country that produced them or through a third country that served as an intermediary. In this regard, it is important to note that the pass-through literature distinguishes between what is called “producer-currency pricing” and “local-currency pricing.” The difference between the two is this: with producer-currency pricing, producers/exporters choose to invoice goods in their own country’s currency. Think of a Chinese exporter that decides to invoice clothing to be shipped to Canada in Chinese renminbi. Local-currency pricing, in contrast, refers to a situation in which this same exporter chooses to invoice in Canadian dollars (i.e., the local currency of the importing country). Some interesting results emerge from this study. First, short-run ERPT was much higher for transactions priced in the producer’s currency; second, pass-through was much higher for goods shipped directly from the producer’s country (regardless of which currency they were invoiced in), as opposed to through a third country. One reason why imports invoiced in local currency exhibit much less pass-through could be that exporters who price in local currency tend to be more concerned about preserving market share in the foreign country. They are prepared to absorb some of the higher costs associated with adverse currency moves to avoid passing them along to their customers. A similar logic might explain the lower pass-through numbers observed on imports that come to Canada through a third country, such as the United States, as opposed to directly from the exporter’s country. Foreign exporters who are less familiar with the Canadian market, or who feel that they have less leverage with local customers, may want to rely on the distribution networks of other, more experienced firms and be more flexible in the prices they charge. However, in almost every case – whether they involved producer- or local-currency pricing – the estimated pass-through coefficients were higher than those reported in previous macro studies, indicating that the endogeneity/heterogeneity problems discussed earlier were significant. ERPT, in other words, is more important than previously believed. The second study that I’d like to describe asks whether gaps between domestic and foreign prices that are larger than normal can be used as predictors of future exchange rate moves.5 M. Devereux, W. Dong and B. Tomlin, “Exchange Rate Pass-Through, Currency Invoicing and Trade Partners,” mimeo, Bank of Canada, 2013. W. Dong and D. Nam, “Exchange Rates and Individual Good’s Price Misalignment: Evidence of Long-Horizon Predictability,” Journal of International Money and Finance 32 (2013): 611–36. BIS central bankers’ speeches The authors collect goods-level data for Japan, the United Kingdom and the United States, calculate deviations from the LOP and test to see if the size of the deviations has what they termed “superior predictive ability” with regard to future movements in the exchange rate. The results for the United States and Japan were particularly encouraging. They showed that the price deviations had significant predictive power, which was positively correlated with the degree of price misalignment and which improved with the length of the forecast horizon (i.e., the performance got better the further out you went). In other words, exchange rates seemed to be moving in the right direction, helping to reduce the deviations from the LOP. Conclusion What can we conclude from all of this? Looks can be deceiving. Casual observation and evidence gleaned from simple charts would seem to raise serious questions about the functioning of domestic and foreign markets, and about the international trading system more generally. Recent studies, however, paint a far more positive picture of the role of exchange rates in influencing relative prices and facilitating the international adjustment. Despite the large and persistent price gaps that are frequently observed between Canadian and foreign prices at the aggregate level, more detailed work suggests that deviations from the law of one price and purchasing-power parity are not as large or as persistent as many believe. While significant price discrepancies exist, the reasons for them can largely be explained and are not evidence of serious market failure. Market forces are at work and are generally pushing prices and the exchange rate in the right direction. However, they do not operate in a vacuum. Their movements are affected by other fundamental forces, and what we pay in Sackville compared with what we pay in Bangor is the end result of many competing pressures. This is not to say that markets are perfect or that there is no room for improvement. Significant trade restrictions and barriers to competition exist, and anything that can be done to reduce them – free trade agreements, for example – is all to the good. Nor am I suggesting that exchange rates are always at their equilibrium or at fundamentally justified levels. As with any asset price, bouts of temporary overshooting and excess volatility are common. However, the broad trends and behaviour of these markets are more positive than many believe and earlier evidence might indicate. Thank you. 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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, before the Senate Standing Committee on Banking, Trade and Commerce, Ottawa, Ontario, 20 November 2013.
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Stephen S Poloz: Opening statement before the Senate Standing Committee on Banking, Trade and Commerce Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, before the Senate Standing Committee on Banking, Trade and Commerce, Ottawa, Ontario, 20 November 2013. * * * Thank you for the opportunity for Tiff and me to be with you today to discuss the October Monetary Policy Report, which the Bank published recently. The Bank aims to communicate our objectives openly and effectively and to stand accountable for our actions before Canadians. One of the best ways to do this is through appearances such as this one. Allow me to spend a few minutes on the highlights of the Report. I’d like to flag some important changes that were introduced with this issue. • We have modified the Report to explicitly capture the uncertainty that is inherent in our outlook. The goal is to present to Canadians a reflection of the evolution of the risks to the inflation outlook that are embedded in our policy, rather than simply compare a snapshot of the current forecast with that of our previous forecast. • The picture is not always perfectly clear, and so we added new measures of ex ante, or before the fact, uncertainty to our five most critical projection variables. We added “rule of thumb” ranges around the base-case projection for the growth of Canadian and U.S. GDP and for Canadian total CPI inflation, as well as for the current level of the output gap and the growth rate of potential output in Canada. • With this, we are reminding ourselves – and those who watch us – that economic projections are subject to considerable uncertainty and are revised over time as new economic data become available. • Monetary policy formulation is more a process of risk management than one of engineering. In our policy deliberations, we evaluate and assess all of the risks, both positive and negative, and use judgment to determine the balance among them. • As is customary in the October Report, we reviewed the forecast for potential output. Due to lower-than-expected labour productivity growth in the past year, as well as the delay in the expected pickup in demand for exports and investment, the forecast for potential output growth was revised down slightly. • Since the Report was published four weeks ago, the outlook for the global and Canadian economies has not changed substantially. • Let me remind you what we reported: – We expect the global economy to expand modestly in 2013. However, its near-term dynamic has changed, and the composition of growth is now slightly less favourable for Canada. – Uncertain global and domestic economic conditions are delaying the pickup in exports and business investment in Canada. This leaves the level of economic activity lower than the Bank had been expecting. – While household spending remains solid and some indicators in the housing sector continue to rise, we still expect a gradual unwinding of household imbalances. – The Bank expects that a better balance between domestic and foreign demand will be achieved over time and that growth will become more selfsustaining. But this will take longer than previously projected. BIS central bankers’ speeches – We are expecting investment growth to contribute to a rebound in the rate of labour productivity growth over the next couple of years. However, demographic factors, primarily the aging population, are expected to put a drag on the growth rate of trend labour input. This drag will largely offset the effects of rising investment. This is why we expect that the growth rate of potential output will remain fairly stable at around 2 per cent over the next three years. – Real GDP growth is projected to increase from 1.6 per cent this year to 2.3 per cent next year and 2.6 per cent in 2015. The Bank expects that the economy will return gradually to full production capacity, around the end of 2015. – Inflation in Canada has remained low in recent months. This reflects the significant slack in the economy, heightened competition in the retail sector, and some other sector-specific factors. – With larger and more persistent excess supply in the economy, both total CPI and core inflation are expected to return more gradually to 2 per cent, around the end of 2015. • Although the Bank considers the risks around its projected inflation path to be balanced, the fact that inflation has been persistently below target means that downside risks to inflation assume increasing importance. However, the Bank must also take into consideration the risk of exacerbating already-elevated household imbalances. • Weighing these factors, the Bank judged on 23 October that the substantial monetary policy stimulus in place remained appropriate and decided to maintain the target for the overnight rate at 1 per cent. Since then, while some new data points have been released, our outlook remains roughly the same, as I mentioned. If you have any questions about the recent data, Tiff and I would be pleased to address them, as well as any other queries that you may have. Thank you. BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Canadian Club of Montreal, Montreal, Quebec, 12 December 2013.
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Stephen S Poloz: Monetary policy as risk management Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Canadian Club of Montreal, Montreal, Quebec, 12 December 2013. * * * Introduction Thank you for those kind words. It is a real pleasure to be here in Montréal. I am going to talk today about managing risks. This is something that we all do in all aspects of our lives – whether we are running a business, pursuing a career, or looking after a family. As we make plans in pursuit of a goal, we take into account what could go wrong – and what can be done to mitigate that. Of course, we can never fully eliminate risks – we can only manage them prudently. As an economist and a central banker, I think a lot about risk. I’m not the only one. In response to what we have experienced these last few years, central bankers around the world are adapting the way they do business. At the Bank of Canada, in recognition of the increased uncertainty that surrounds us, we are adjusting our lens on risks, how we evaluate them and how they enter into decisions about monetary policy. That is my topic this afternoon. Monetary policy formulation Not everything has changed, far from it. The best way for the Bank of Canada to deliver on its mandate is, as always, to keep inflation low, stable and predictable. In 1991, the Bank adopted an inflation target and, since 1995, our target has been 2 per cent inflation. The target is sacrosanct. And, in more than two decades of inflation targeting, we have generally succeeded: on average, inflation has been very close to the target. This has not happened by itself. Like navigating a ship, we have had to adjust to the currents around us and to bouts of foul weather. Some of the challenges are minor, calling for temporary adjustments in course or speed. Others may involve a major detour. In worst-case scenarios, there are risks of running aground, or even capsizing. In all cases, we have to anticipate as well as react. The Bank’s Governing Council sets the policy interest rate with the goal of achieving our 2 per cent inflation target. Central to this decision is our view of the most likely path for the Canadian and global economies. Conditional on these forecasts, there is a unique path for interest rates that should bring us back to target, just like the captain who plots the intended course for his ship. At that point in the process, monetary policy can seem like precision engineering. But just like at sea, in monetary policy, the view is not always perfectly clear. Given what we’ve been through and continue to experience, our forecasts are not pinpoint numbers; rather, they represent ranges of likely outcomes. Likewise, our economic models are a better source of questions than answers. To make sure that such uncertainty is not just acknowledged but is actually embedded in our policy decisions, we have incorporated explicit “rule-of-thumb” ranges around the most critical variables for our projection. In doing so, we are reminding ourselves – and those who watch us – that, especially in the wake of the crisis, economic projections are subject to considerable uncertainty. BIS central bankers’ speeches Indeed, while Canada came through the global financial crisis and ensuing Great Recession better than our G-7 peers, we are taking longer than expected – or desired – to get home. Our economy still has not returned to full capacity, and inflation has been running persistently below our 2 per cent target. Because of the unprecedented nature of the crisis and subsequent recession, the global recovery has been anything but smooth or normal. As we navigate these uncharted waters, we are especially vigilant in our lookout for risks that could push us off course. Assessing risk through two lenses This lookout is an important element of our policy deliberations. We assess how risks could interact with each other. We gauge their potential impact. And we use judgment to determine the balance among them, both today and in prospect. In fact, monetary policy formulation these days is more a process of risk management than one of precision engineering. It is important to stress that risks are not part of our baseline forecast – they are not what the Bank expects to see, but rather, they are the possible deviations from what we anticipate. We work to avoid or, at least, mitigate them. The Bank of Canada looks at risks through two lenses: (i) the possible impact on the outlook for real economic activity and inflation, and (ii) the possible impact on the stability of the financial system. These two sets of risks are related but, for the moment, let me discuss them separately. Targeting inflation is necessarily a forward-looking activity. It is informed by the work of economic forecasters who crunch the data and use models to assess the most likely future path of inflation. As our inflation target is symmetric, we care about both the upside and downside risks to inflation. Of course, when we are already below target, as we are today, we care more about downside risks than upside ones. The Bank’s projection for inflation and its assessment of the risks around that projection are published quarterly in our Monetary Policy Report (MPR). Risks to financial stability are viewed through a separate lens. The risks we consider are those that have the potential to disrupt or harm the financial system – namely, the downside, or bad, risks. Our primary objective is to determine the likelihood that they materialize and, if they were to occur, their impact on financial institutions and the functioning of markets. The Bank examines such risks in depth twice a year in our Financial System Review (FSR), the most recent of which was published just two days ago. While we examine the two sets of risks from different perspectives, we take into consideration the interplay between them. We learned, through the painful experience of the recent crisis, that pursuing economic stability without due regard for financial stability risks achieving neither. Both are necessary, but neither is sufficient. Both are central complements to each other, not substitutes. It follows naturally that, as policy-makers, we consider the risks to economic stability and financial stability in an integrated fashion. Like the two lenses of binoculars, this adds depth to our understanding of the forces at play. Avoiding Disaster Let me use a couple of examples. People ask me every day about the potential, in our present situation, for runaway inflation or runaway deflation. Indeed, sometimes the same person is worried about both! These risks sit at the extremes of the distribution of what’s possible. I’ll address each of them in turn. BIS central bankers’ speeches Runaway inflation Let’s talk first about the risk of runaway inflation. This happened 40 years ago here in Canada and in most advanced economies. Prices spiralled up, economic growth was weak and unemployment was rising. Inflation got away from us. People’s expectations of future inflation became unanchored, pushing up actual inflation. Interest rates were also high, but savings were eroded by the high inflation. When the Bank of Canada finally made a determined effort to bring inflation back under control, our economy went through a major recession. Some wonder if today’s easy monetary policy in Canada – alongside quantitative easing in other countries – could lead to a similar outcome. Their fear is that all that money creation is eventually going to result in an explosion in inflation. They needn’t worry. The situation now is different from the early 1970s. Monetary stimulus today is offsetting the serious and still ongoing downside shocks resulting from the crisis. Of course, it is worth asking what will happen when those negative forces abate. Could all that additional liquidity fuel inflation then? My answer is: central banks will need to drain that extra liquidity from the system at some point, as the economy heals. While I don’t want to underestimate the challenge of getting that exit exactly right, I am confident that we have the ability to keep inflation from taking off. In short, we will remain vigilant. We are prepared to remove monetary stimulus when it’s no longer needed to offset the forces that currently are pulling inflation below target. But, right now, it looks to us like it will take around two years to get inflation back up to 2 per cent. Deflation Let’s switch gears and look at the risk of outright deflation. Like out-of-control inflation, deflation can become a spiral, but a downward one. Expectations become unanchored on the downside, and people put off their purchases because they expect things to be less expensive later. Demand declines with prices, while the weight of debt on the economy grows. In the Great Depression, consumer prices in Canada fell 25 per cent, and national output dropped by almost a third. The human cost was staggering, with unemployment reaching 20 per cent. A milder form of deflationary trap has nagged Japan for the past 20 years. What I am describing is an economy-wide process of deflation, which is quite different from individual prices falling because of improved competitiveness in an economy that is still growing strongly. Today, the concern is that even though policy-makers were successful in avoiding global deflation in the wake of the 2008 crisis, there is still a risk that inflation could creep down into deflationary territory as the aftershocks of this crisis persist. It is, at least in part, to counter that risk that central banks in a number of countries have kept interest rates very low and used unconventional monetary policies, such as quantitative easing, to provide additional stimulus to their economies. History has taught us that deflation usually comes in the wake of a financial crisis. This was true of the Great Depression, and of the Japanese deflation of the 1990s. Perhaps the most important lesson of the crisis, then, is that a stable financial system is necessary to keep inflation low, stable and predictable – and limit the risk of falling into a deflationary trap. The policy response – Where does financial stability come in? This is why the G-20 Leaders launched a reform agenda in 2009 to make the global financial system more robust. In short, we never want to go through this again. Since the crisis, central banks have also been focusing greater attention on financial stability issues. In fact, BIS central bankers’ speeches this is a return to our roots. Many central banks were created primarily to preserve financial stability. This includes the Bank of Canada, which came into being during the Great Depression. The first line of defence against a buildup of financial imbalances is effective regulation and supervision. In Canada, it is ultimately the Minister of Finance who is responsible for the stewardship of the financial system. Regulation is carried out by the Office of the Superintendent of Financial Institutions, deposit insurance by Canada Deposit Insurance Corporation, and consumer awareness by the Financial Consumer Agency of Canada. The Bank of Canada’s assessment of financial stability risks is an important contribution to this team effort. It is also critical, as I mentioned earlier, to the Bank’s policy-making. Today, we are focused in particular on the risks associated with household imbalances. To explain, let me back up a bit. At the height of the crisis, although our financial system remained sound, our exports collapsed, causing a recession. To support economic growth, we have relied mainly on household spending, supported by exceptionally stimulative monetary policy. But there are trade-offs, lots of them. Today, the most obvious is that prolonged low interest rates can result in the development of imbalances in the household sector. In Canada, we have seen rising levels of household indebtedness, stretched house-price valuations and overinvestment in housing. To address these imbalances, the Finance Minister tightened mortgage insurance rules four times, among other measures, and the Superintendent of Financial Institutions introduced stronger mortgage underwriting standards for Canada’s banking institutions. In the wake of these measures, a constructive evolution of household imbalances began around the middle of last year. Growth in household borrowing has moderated, and residential investment is on a more sustainable track. Those indicators have picked up again, we think mainly because people pulled forward their plans when mortgage rates started to move up during the summer. We expect these imbalances to stabilize and then gradually unwind in coming years. In our base-case scenario, the Bank expects a soft landing in housing and a pickup in exports and investment. This rotation will relieve the tension between low demand and household imbalances. Nonetheless, the risks around this base case need to be managed. There is a risk that household imbalances could keep building and set the stage for a sharp correction down the road. Such a correction would be a risk to both the Canadian economy and our financial system. Our current monetary policy weighs this risk against the risk of inflation falling even further below target. This zone of balance is relevant today and in prospect, as we expect both risks to diminish over the next two years or so. This is what I mean when I describe monetary policy as an exercise in risk management. Credibility counts Our flexible inflation-targeting framework gives us the room to manoeuvre in the face of unusual shocks. This only works if expectations are well anchored: the public has to be confident that we will get to the 2 per cent target. Our commitment to the inflation target must remain credible. Credibility is coin. It is earned only through years of sound policy. Without it, low and stable inflation could only be achieved at considerable short-run cost to the economy – as was our experience in the early 1980s, when we tackled runaway inflation. BIS central bankers’ speeches Credibility must be employed wisely. We think of it as an investment. By using credibility to exercise the framework’s flexibility, we are working to maintain stable financial conditions that will support the expansion of capacity and return the economy to its full potential. As the process unfolds, we anticipate there will be a future payoff of enhanced credibility. As we decide policy, we cannot take credibility for granted; we must keep earning it by ensuring, first and foremost, that monetary policy remains focused on keeping inflation on target. Conclusion Let me conclude. I’ve described how we manage a menu of risks in our policy decisions: We look at risks through two lenses. We are concerned with the big risks of runaway inflation and deflation and are acting to keep them remote. We have learned, the hard way, that financial stability is a necessary condition for low and stable inflation, and we are working here in Canada and around the world to improve the resilience of the financial system. Our current monetary policy balances the risk that inflation could drift even further below target against the risks of exacerbating financial system imbalances. As central bankers, here in Canada and globally, we are in new territory. It brings to mind the sailors of another era who were driven far off course by a nasty storm. When things calmed, they found themselves in the southern hemisphere. Suddenly the navigational chart that they relied on – the night sky – was completely different. We have every reason to believe that, after the experience of the crisis is behind us, central banking will be defined very differently than it was just five years ago. We know now that economic and financial stability are intrinsically linked, and we are figuring out as we go how to better integrate the two in our analysis and research, and in our policy. On a technical level, we are actively building new models and adding new detail to our existing ones. We are spending more time talking to real people making real economic decisions, to understand better the forces we are facing. And, we are communicating differently, not just more, but with more transparency, with due regard to the uncertainty around us. I am confident that we’ve got it roughly right, given what we know and especially what we don’t. Just like those sailors on the open seas, we will adapt and thrive – and find our way home. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 22 January 2014.
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Stephen S Poloz: Summary of the latest Monetary Policy Report Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 22 January 2014. * * * 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. Before we take your questions, allow me to note the highlights of the Report. • Inflation in Canada has moved further below the 2 per cent target. This is due largely to significant excess supply in the economy and heightened competition in the retail sector. The path for inflation is now expected to be lower than previously anticipated for most of the projection period. • The Bank expects inflation to return to the 2 per cent target in two years or so, as the effects of retail competition dissipate and excess capacity is absorbed. • The global economy is expected to strengthen over the next two years, rising from 2.9 per cent growth in 2013 to 3.4 per cent in 2014 and 3.7 per cent in 2015. • The United States will lead the way, helped by diminishing fiscal drag, accommodative monetary policy and stronger household balance sheets. The improving U.S. outlook is affecting global bond, equity, and currency markets. • Growth in other regions is evolving largely as projected in October. • Global trade growth plunged after 2011, but is poised to recover as global demand strengthens. • In Canada, economic growth improved in the second half of 2013. However, there have been few signs of the anticipated rebalancing towards exports and business investment. • While we are doing more work to understand the wedge between the level of Canadian exports and that of foreign demand, this remains difficult to explain. We are therefore taking a conservative approach to our forecasts for exports, and assuming the wedge will remain. • That said, the U.S. recovery is becoming more broad-based, including higher investment spending by companies, and that, as well as the recent depreciation of the Canadian dollar, should help to boost exports. This, in turn, should lead to stronger business confidence and investment here in Canada. • Meanwhile, recent data have been consistent with the Bank’s expectation of a soft landing in the housing market and a stabilization of household indebtedness relative to income. • Real GDP growth is projected to pick up from 1.8 per cent in 2013 to 2.5 per cent in both 2014 and 2015. This implies that the economy will return gradually to capacity over the next two years or so. • Our recent analysis has given us an improved, yet still incomplete, understanding of the inflation picture. We now believe the effect of heightened retail competition will subtract about 0.3 percentage points from core inflation in 2014. This effect will be more persistent than initially thought. • This finding, though, does not explain all of the weakness in inflation. And so, we are exploring whether the output gap has a greater impact on inflation than previously BIS central bankers’ speeches believed, especially when the gap is persistent. This interpretation seems to be relevant for other countries, as well as Canada. • While increased competition will have a permanent effect on the level of prices, it will have a transitory effect on the rate of inflation. As such, we believe policy should look through it. • Although the fundamental drivers of growth and future inflation appear to be strengthening, inflation is expected to remain well below target for some time, and therefore the downside risks to inflation have grown in importance. At the same time, risks associated with elevated household imbalances have not materially changed. • Weighing these considerations, the Bank judges that the balance of risks remains within the zone articulated in October, and therefore has decided to maintain the target for the overnight rate at 1 per cent. The timing and direction of the next change to the policy rate will depend on how new information influences this balance of risks. 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 John Molson School of Business, Concordia University, Montreal, Quebec, 7 February 2014.
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Tiff Macklem: Flexible inflation targeting and “good” and “bad” disinflation Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the John Molson School of Business, Concordia University, Montreal, Quebec, 7 February 2014. * * * Accompanying charts can be found at the end of the speech. Introduction Good afternoon. I want to particularly thank Professor Switzer for inviting me to speak here at the John Molson School of Business. I grew up in Montréal and this occasion is a sort of a closing of a circle for me. My first speech as Senior Deputy Governor was here in Montréal and this will be my last. In a few months, I will be joining another outstanding business school – the Joseph L. Rotman School of Management. So speaking to business students here in Montréal is a nice bridge from my past to my future. I want to use this opportunity to discuss a topic that is at the heart of the Bank of Canada’s mission: inflation control. I was part of the team in the early 1990s that designed and implemented the Bank’s inflationtargeting framework. We developed the framework against a backdrop of high and variable inflation. Those of you who are old enough will recall the crippling effects of double-digit inflation and mortgage rates that rose above 20 per cent in the 1980s. Fortunately, inflation targeting worked – indeed, better than many imagined. We’ve now had more than two decades of low, stable and predictable inflation, and Canadians have confidence in the value of their money. Low, stable and predictable inflation has supported solid economic growth and a well-functioning and more stable labour market. And it provided both a beacon and an anchor as we navigated the global financial crisis. Inflation targeting has served Canadians well in tranquil and turbulent times. But this is not the end of monetary history. Globally, the financial crisis shook central banking to its core and took it back to its roots as a lender of last resort and an important player in maintaining financial stability.1 The fallout of the crisis has been a painfully slow global recovery that has reduced job prospects for a generation of new workers in many advanced economies, and turned the tables on inflation control. Inflation targeting was conceived as a monetary policy framework to get inflation down and hold it there. But, today, the challenge is to get inflation up. Most advanced economies are experiencing declining inflation or disinflation. Over the past two years, inflation in advanced economies has fallen by 1.5 percentage points on average and is below target in most of these economies, Canada included (Chart 1). I want to focus my talk today on what this disinflation means for our inflation-control policy. I’ll begin with a brief review of how our inflation-targeting regime works, and then discuss the post-crisis inflation experience, the factors contributing to disinflation and the implications for monetary policy. See T. Macklem, “Raising the House of Reform” (speech to the Rotman Institute for International Business, Toronto, ON, 7 February 2012); M. Carney, “A Monetary Policy Framework for All Seasons” (speech to the U.S. Monetary Policy Forum, New York, New York, 24 February 2012). BIS central bankers’ speeches To give you a hint of where I am going, not all disinflations are created equal. Some are “good” disinflations caused by increased competition and higher productivity growth, while others are “bad” disinflations stemming from weak demand for goods and workers that puts downward pressure on prices and wages. In theory, monetary policy should respond differently to good and bad disinflation. In practice, this is complicated by uncertainties surrounding our measurements and projections. Our work at the Bank of Canada is both to sharpen the analysis as much as we can and, at the same time, to take account of the risks and uncertainties as we determine the appropriate course for monetary policy to achieve our inflation target. Let me expand. Inflation Targeting 101 The Bank’s mandate is 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.”2 High and volatile inflation in the 1970s and 1980s taught us that the best way for us to achieve these objectives is to keep inflation low, stable and predictable. When we adopted our inflation-targeting monetary policy in 1991, we were virtually alone. No other G-7 country was doing this. New Zealand, the first country to adopt inflation targeting, had done so only nine months before us. And there was very little in the academic literature on inflation targeting. Since 1995, the target has been to achieve an annual total rate of inflation of 2 per cent – the midpoint of our control range of 1 to 3 per cent – as measured by the consumer price index (CPI). The target is reviewed jointly with the federal government approximately every five years, and was last renewed in 2011.3 To achieve that target, an essential component of our monetary policy framework is a flexible exchange rate. The floating exchange rate is part of the monetary transmission mechanism. It allows the Bank to pursue its own “made-in-Canada” monetary policy that is directed at achieving 2 per cent inflation in Canada and stabilizing our economy. The flexible exchange rate also serves as a kind of shock absorber for the Canadian economy, helping it absorb and adjust to shifts in the global economy.4 In light of the recent depreciation of the Canadian dollar, it bears stressing that the Bank does not have a target for the exchange rate – it has an inflation target. The exchange rate is determined in markets, and we neither promote any specific value for the Canadian dollar, nor thwart its movements. Our inflation-targeting policy has three important features. It is symmetric. The Bank is equally concerned about inflation rising above or falling below the 2 per cent target. High and variable inflation erodes purchasing power, creates uncertainty, distorts investment decisions, and causes arbitrary redistributions of wealth between savers and borrowers. But sustained negative inflation – or deflation – is even more pernicious. The 2 per cent target provides a buffer that gives monetary policy greater scope to avoid the risk that disinflation could deteriorate into outright deflation. In a deflation, inflation expectations become unanchored on the downside, and people begin delaying Preamble to the Bank of Canada Act, R.S.C., 1985 c. B-2. Bank of Canada, “Renewal of the Inflation-Control Target: Background Information – November 2011.” T. Macklem, P. Osakwe, H. Pioro and L. Schembri, “The Economic Consequences of Alternative Exchange Rate and Monetary Policy Regimes in Canada,” paper delivered at the Bank of Canada conference, “Revisiting the Case for Flexible Exchange Rates,” November 2000. BIS central bankers’ speeches purchases because they expect the things they buy will be less expensive in the future. This depresses demand. And as prices and wages fall, the real burden of mortgages and other nominal debt commitments increases, further depressing demand. Today, with inflation at about 1 per cent, prices are rising, not falling. And we expect inflation to increase gradually to the 2 per cent target. But with inflation persistently below target, we are more concerned about downside risks to inflation than upside ones. It is forward looking. Monetary policy actions take time – about two years – to work their way through the economy and to have their full effect on inflation. For this reason, monetary policy must always be forward looking, with the Bank setting the policy rate based on its judgment as to how inflation is likely to evolve. Making that assessment requires a careful examination of the economic evidence pertaining to the balance of supply and demand in the economy and other factors affecting inflation. To help us see through temporary fluctuations in inflation, the Bank uses core inflation, which strips out the volatile components of the CPI, as an operational guide for setting policy in pursuit of the target for total CPI inflation.5 In our baseline forecast, demand is expected to strengthen, gradually absorbing excess capacity in the economy. As this slack is taken up, core and total inflation are expected to increase to target over the next two years or so. It is flexible. In assessing whether the stance of monetary policy is appropriate to achieve the inflation target, the Bank must make a judgment regarding the horizon for returning inflation to target. Flexible inflation targeting provides the scope to consider financial stability risks and to manage the volatility that monetary policy actions may induce in the economy and financial markets. In the current context, an important element in our monetary policy decisions – which has been highlighted in our recent policy announcements – is the need to weigh the risks of exacerbating elevated household imbalances against the downside risks to inflation when inflation is already below target. The Bank’s record of inflation control over more than 20 years is impressive. Since1991, inflation in Canada has averaged 2 per cent, as measured by total CPI, and its standard deviation has fallen by roughly two-thirds compared with the 1970s and 1980s (Chart 2). Moreover, the persistence of inflation, as measured by the serial correlation in inflation, fell from 0.8 between 1975 and 1990 to only 0.1 since 1995. Nowadays, fluctuations around the target are typically short-lived, so the best forecast for inflation is 2 per cent – the target. What could be simpler? Low inflation is also a means to an end – better economic performance. Low, stable and predictable inflation has been associated with more stable economic growth in Canada and lower and less-variable unemployment (Table 1). The average rate of unemployment has fallen, and fluctuations in unemployment, as measured by its standard deviation, have been reduced by more than one-third.6 Not surprisingly, other countries have followed Canada’s lead. Since 1991, more than 25 other advanced or emerging-market economies have become inflation targeters.7 Our main measure of core inflation is CPIX, which strips out from total inflation eight of the most volatile components of the consumer price index as well as the impact of indirect tax changes on the remaining components. For more on the improved functioning of labour markets with low and stable inflation, see T. Macklem, “A Measure of Work” (speech to the Winnipeg Chamber of Commerce, Winnipeg, MB, 4 October 2012). G. Paulin, “Credibility with Flexibility: The Evolution of Inflation-Targeting Regimes, 1990–2006,” Bank of Canada Review (Summer 2006): 5–18; S. Jahan, “Inflation Targeting: Holding the Line,” International Monetary Fund, Finance and Development, March 2012. BIS central bankers’ speeches The recent behaviour of inflation in Canada With that context, let’s look at the recent behaviour of inflation in Canada. Following the global financial crisis, total inflation in Canada fell sharply, to a low of –0.9 per cent in July 2009, largely as a result of a drop in the world price of oil, which plummeted from US$140 per barrel in the summer of 2008 to US$35 later that year. With the resumption of growth in most advanced economies, global oil prices rebounded in 2010 to US$90 per barrel, and total inflation rose to more than 3 per cent in 2011 (Chart 3). By comparison, core inflation remained relatively stable around 2 per cent during this period. However, since 2012, both core and total inflation have drifted lower and have been below 2 per cent for the past 20 months. Other measures of core inflation have also declined. Indeed, the disinflation since 2012 is evident in all of our measures of inflation (Chart 4). And, if we look at individual components of the CPI basket, it is apparent that the weakness is widespread, with the prices of about three-quarters of the consumer basket now increasing at a pace of less than 2 per cent over the past year (Chart 5). What explains disinflation in Canada? Global disinflation A number of studies have indicated that there is a global dimension to inflation, which is currently low and falling across a wide range of advanced economies.8 A convenient way to look at this is by using factor analysis, a statistical method that summarizes the common variability among the inflation rates of different countries. When we look at the evolution of global inflation, as measured by this common factor, we see a decline in global inflation since 2012 (Chart 6).9 Global total inflation is strongly correlated with global energy and food price inflation – the corresponding correlation coefficients are 0.5 and 0.6, respectively. This suggests that much of the recent decline in global total inflation can be explained by the recent fall in world energy and food prices (Chart 7). However, longer-term trends are more likely a reflection of movements in global core inflation. The recent decline in global core inflation is more difficult to understand (Chart 8). It may reflect the large and persistent amount of economic slack in many advanced countries (Chart 9).10 However, it is less apparent how economic slack can explain why disinflation is occurring now, since core inflation was relatively stable from 2009 to 2011, when the output gaps in most countries were even larger. It may be that the sensitivity of inflation to the output gap increases as the gap becomes more persistent, and this could be reinforced by changes in inflation expectations. Inter alia M. Ciccarelli and B. Mojon, “Global Inflation,” The Review of Economics and Statistics 92, no. 3 (2010): 524–35. For international comparability, core inflation is defined here as consumer price inflation minus food and energy. Still, there are differences across countries with regard to the components that enter the measurement of consumer prices. The charts show standardized inflation rates, whereby all inflation rates have a mean of zero and a standard deviation of one. Some have argued that increasing trade with China has helped to keep inflation low. While this has been confirmed empirically (L. Morel, “The Direct Effect of China on Canadian Consumer Prices: An Empirical Assessment,” Bank of Canada Discussion Paper No. 2007–10; D. Côté and C. De Resende, “Globalization and Inflation: The Role of China,” Bank of Canada Working Paper No. 2008–35), the overall effect seems to be quantitatively small, and it has become even less important recently, since Chinese prices are no longer falling and China’s market share of imports to advanced economies is no longer rising. BIS central bankers’ speeches Looking at the relevance for Canada of global inflation developments, it is evident that Canada’s total inflation rate co-moves substantially with the common factor in inflation among advanced economies, underscoring the importance of energy and food prices for movements in total CPI inflation in Canada. In contrast, relatively little of the variance of core inflation in Canada appears to be related to movements in global core inflation (Chart 10). The decline in Canadian core inflation in 2012 has been stronger than what was observed at the global level, which is surprising, given that economic slack in Canada looks to be smaller than elsewhere. This suggests that country-specific factors are likely to be more important in driving core inflation dynamics in Canada. Subdued domestic fundamentals The expectations-augmented Phillips curve provides a model for understanding the domestic forces at work on core inflation. In its simplest form, this model expresses core inflation as a function of inflation expectations and a measure of economic slack, πt Et πt = ( +1)+b(yt-y¯t)+∊t where πt is inflation in this period, Et(πt+1) is the expected rate of inflation next period, and – y¯t is the gap between actual output yt and potential output y¯t.11 The error term ∊t captures other drivers that are missing from the equation, for example, price or supply shocks triggered by factors such as unusual weather or shifts in competition. yt An important point to note is that the estimated coefficients on the determinants of inflation in this relationship tend to be very small, and the statistical relationship tends to be weak. While this is not surprising, given Canada’s record of stable inflation since the adoption of inflation targeting, it implies that fairly large variations in the output gap are needed to induce economically meaningful movements in core inflation. This stylized representation is, of course, a simplification of the true inflation process, but it is useful to help us assess the role of potential drivers that could be depressing inflation. Persistent economic slack Let’s start with the output gap. Slack in the Canadian economy remains significant (Chart 11). Taking into account the full range of indicators of capacity pressures and the uncertainty surrounding any point estimate, we concluded in our most recent Monetary Policy Report that the amount of excess supply in the economy in the fourth quarter of 2013 was between ¾ and 1¾ per cent. Our conventional measure, which is based on a statistical method that combines several data sources, suggests that the output gap was close to the lower end of this range.12 However, an alternative structural approach suggests that the output gap was closer to 1¾ per cent in the fourth quarter.13 This reflects material slack in total hours worked, as well as a level of labour productivity that is considerably below its trend. Other labour market indicators also point to a greater degree of slack than the conventional measure. For Potential output is the level of output that can be sustained in an economy without adding to inflationary pressures. Identifying the current level of potential output is necessary to estimate the output gap, which is a key measure of inflation pressures. The conventional measure is based on the extended multivariate filter method (see L. Butler, “The Bank of Canada’s New Quarterly Projection Model Part 4. A Semi-Structural Method to Estimate Potential Output: Combining Economic Theory with a Time-Series Filter,” Technical Report No. 77, Bank of Canada, 1996. For a description of the structural approach, see “Appendix A: Potential Output” on page 27 in the October 2013 Monetary Policy Report. BIS central bankers’ speeches example, the proportion of involuntary part-time workers and the average duration of unemployment are still elevated (Chart 12). Explaining the current level of core inflation with the Phillips curve is not easy. Simple econometric estimates of the coefficient on the output gap, b, would suggest a value of around 0.1. Conditional on our assessment of economic slack as 1¼ per cent (the midpoint of the range), this would predict core inflation of 1.9 per cent. This is well above actual inflation, which is running at about 1 per cent. Of course, the true coefficient b could be bigger than 0.1. As you might expect, we have looked at this at the Bank of Canada. And indeed, we find that controlling for factors not captured in this simple equation could increase the coefficient to around 0.3.14 This produces a predicted value for core inflation of 1.6 per cent. This is better, but it still leaves a significant portion of the weakness in inflation unexplained. Given the high degree of uncertainty around real-time estimates of the output gap, it is possible that the level of economic slack is greater than currently estimated. Indeed, the range we provide in the Monetary Policy Report is designed to convey this uncertainty. However, even assuming a coefficient of 0.3 on the output gap, we would need to more than double our estimate of the degree of slack in order to predict an inflation rate of close to 1 per cent. This is not realistic. In addition to economic slack, other factors must be causing disinflation. Changing inflation expectations? What about inflation expectations? During the past year, survey forecasts of short-term total inflation have moved lower, in line with changes to actual inflation. The January Consensus Economics forecast for total CPI inflation is now 1.5 per cent for this year and 1.9 per cent for next year (Chart 13). According to the Bank’s Business Outlook Survey, inflation expectations remain steady, with almost all firms expecting CPI inflation to be within the Bank’s 1 to 3 per cent inflation-control range over the next two years, and the majority expecting inflation to remain in the bottom half of that range, consistent with the Bank’s basecase projection. Market-based measures of longer-term inflation expectations continue to be consistent with the 2 per cent inflation-control target, providing little evidence that inflation expectations are becoming unhinged from the 2 per cent target. Of course, the longer inflation remains below target, the more likely inflation expectations are to decline. This is something to watch closely, but to this point, it is hard to explain the observed disinflation as the result of a shift in expectations. This leaves only the error term in the Philips curve to account for the unexplained weakness in inflation. What could this negative error reflect? A wide range of evidence points to increased competition in the domestic retail sector. Increased domestic retail competition The increase in retail competition is, in many ways, a welcome development. It means lower prices and more selection for consumers. And if retail margins are holding up, which they appear to be, it also suggests that retailers are more productive, which increases real incomes and living standards. Competitive pressures in the retail sector in Canada appear to have intensified on three fronts: newer and bigger retailers, cross-border shopping and online purchasing. For instance, empirical work estimates a stronger relationship between a subset of core inflation and the output gap. BIS central bankers’ speeches Walmart opened its discount stores in Canada in 1994 and, in 2006, began transforming many of them into supercentres that offer food as well as general merchandise. By the end of 2013, 61 per cent of the company’s outlets were supercentres. This new retailing strategy, as well as Walmart’s pricing, has increased the competitive pressures on traditional retailers. In addition, Target and a number of other American retailers have recently entered, or are planning to enter, the Canadian marketplace.15 So far, despite the significant pressure on prices, retail profit margins are holding up, reflecting improved productivity in the sector (Chart 14). The composition of the sector has changed toward more profitable retailers: chain stores have become an increasingly large share of the retail sector, and their profit margins are almost three times higher than nonchain outlets (Chart 15). Measured productivity in the retail sector has also been improving faster than productivity for the total economy (Chart 16). Retail competition may also have intensified as a result of the increase in duty exemptions announced in the federal government’s 2012 budget. Following the change, the number of travellers returning from the United States by car after an overnight stay (likely for shopping trips) rose significantly.16 While the volume of overnight car trips displays a significant seasonal pattern (with peaks around the summer months), the average level increased from around 150,000 per month in the five years prior to the duty change to nearly 270,000 per month since then (Chart 17). I would not want to overplay the impact of this change – the share of nominal consumption by Canadians abroad is only about 4 per cent and the recent depreciation of the Canadian dollar will work in the other direction. Nonetheless, increased cross-border shopping may have been a reinforcing factor. Finally, online shopping has opened a new front on the competitive landscape. More consumers are using the Internet to purchase a wide range of goods and services. Although this remains a small component of consumption, online shopping is adding choice and new competition to the retail sector.17 What does all this mean for prices? Subdued inflation has been reflected in the unusual softness in the prices for core food items and core non-durable goods, two sectors where anecdotal evidence suggests that competition has intensified. Food alone accounts for 17 per cent of the core CPI basket, and it exerted the largest drag on core inflation in 2013 (Chart 18). Core food inflation is very low by historical standards, and although much of this weakness reflects a decline in global food price inflation, the fall in recent quarters is outsized relative to the drop in global food price inflation (Chart 19). The agriculture component of the Bank’s commodity price index stabilized in late 2012 but core food inflation continued to decrease, consistent with the evidence of greater competition in grocery and general merchandise stores in Canada. Looking forward, ongoing structural change in this sector suggests that competitive pressures are likely to remain intense for some time. However, the recent depreciation of the Canadian dollar can be expected to offset at least some of the downward pressure on retail food prices. Other notable retail entrants include Marshalls, J. Crew and Nordstrom. The 2012 federal budget raised duty exemptions on goods purchased abroad. The exemption for a stay of 24 to 48 hours was increased from $50 to $200, while the exemption for a trip longer than 48 hours was increased from $400 to $800, both effective 1 June 2012. In total, in 2012, Canadians placed nearly 164 million orders, valued at approximately $18.9 billion. This dollar amount of spending represents only about 1.9 per cent of nominal consumption in Canada (Canadian Internet Use Survey, Statistics Canada). BIS central bankers’ speeches For non-durable goods, which include items such as personal care products, price growth has eased significantly in recent quarters, with prices outright falling in the fourth quarter of 2013 (Chart 20). In fact, the last time the rate of inflation for non-durable goods was lower than the current level was when Walmart entered the Canadian market in the mid-1990s. Overall, our expectation is that while increased competition will have a permanent effect on the level of prices, its impact on the rate of inflation will be transitory. Our best judgment is that more intense competition will subtract around 0.3 percentage points from core inflation in 2014. It is difficult to predict how long increased competition will weigh on inflation, but in our base-case projection we assume that it will continue to drive prices lower for about another year. Implications for monetary policy As we just saw, subdued inflation appears to reflect a significant and persistent amount of excess supply in the economy and heightened competition in the retail sector. Our best estimates of the impact of these two factors still leave some of the disinflation unexplained, but together they are not far off. With at least a partial diagnosis, it is time to consider the treatment. This is most easily demonstrated by comparing the effects of a fall in aggregate demand and an increase in competition in a very simple, stylized model of the economy. The model consists of the Phillips curve previously outlined, equations linking aggregate demand to interest rates and a monetary policy rule in which the policy interest rate responds to divergences of actual inflation from the target and of actual output from potential output (a Taylor rule). An increase in competition in this model directly lowers inflation but barely affects the output gap (Chart 21). In contrast, a fall in aggregate demand results in an increase in slack in the economy and, through the Phillips curve relationship, this leads to lower inflation. In both cases, inflation falls, but only in the latter is there slack in the economy. The monetary policy implications of these two scenarios are significantly different. In the case of an increase in competition, monetary policy largely stays the course, leaving the policy interest rate essentially unchanged. For the fall in aggregate demand, both output and inflation decline, and the Taylor rule calls for a cut in interest rates to stimulate demand and bring inflation back to target. The different policy responses reflect the distinction between “good” disinflation and “bad” disinflation. An increase in competition in a specific sector causes prices in that sector to fall relative to other prices. This is a relative price change, rather than a generalized change in prices. It reflects market forces at work, and it is not a sign of weakness in the economy. Consumers benefit from lower prices, and increased competition is likely to mean higher productivity in the sector – both good things. Hence, there is little need for monetary policy to try to counter this “good” disinflation, provided that inflation expectations remain well anchored. A decline in aggregate demand, however, reduces employment and income at the same time as inflation declines for a broad range of goods and services. This is “bad” disinflation and something to be resisted by monetary policy. These stylized simulations arbitrarily assume that the persistence of inflation is the same in both scenarios. And with the same persistence, monetary policy reacts more to a shortfall in demand than an increase in competition. If the impact of increased competition on the rate of inflation is less persistent, as we expect, this conclusion is only reinforced. That’s the theory. What about the practical world of monetary policy? We need to do our best to determine why inflation is below target, but no matter how hard we try, there will be uncertainty about our diagnosis. Moreover, the economy is enormously BIS central bankers’ speeches more complicated than the simple model I used for illustration. We don’t have a crystal ball to help us see the future. And monetary policy decisions are not prescribed by a simple rule. For all these reasons, monetary policy is not a mechanical exercise. It is better described as risk management.18 There are many sources of uncertainty behind our assessment of the disinflationary forces at work in Canada, ranging from the role of global factors to the amount and impact of excess supply in our economy, the importance and duration of competition effects, and, importantly, the behaviour of inflation expectations. These considerations are all embedded in our decisions. But theory combined with measurement is at least a crude guide. And as we observe disinflation across a number of advanced countries, the message from theory is that monetary policy should work to counter “bad” disinflation stemming from weak demand, but look through “good” disinflation from increased competition and improved productivity. Conclusion Let me wrap up with the Bank’s outlook and a few concluding remarks. As we noted in the Monetary Policy Report that the Bank issued two weeks ago, inflation has moved further below the 2 per cent target in recent months. At the same time, Canada’s economic growth strengthened in the second half of 2013, and prospects have improved somewhat, with expectations of firmer growth in the United States. While as yet there are no signs of a rebalancing toward exports and business investment in Canada, the strengthening of the global economy and the recent depreciation of the Canadian dollar should foster a broadening of the composition of growth in Canada. As excess capacity is gradually absorbed and the effects of increased competition wane, the Bank expects that both core and total CPI inflation will return to 2 per cent in about two years. The depreciation of the Canadian dollar may also boost some import prices directly, although our experience is that the pass-through to core inflation is relatively small. While the fundamental drivers of growth and future inflation appear to be strengthening, inflation is expected to remain well below target for some time. Therefore, the downside risks to inflation have grown in importance. At the same time, the risks associated with elevated household imbalances have not changed materially. Weighing these considerations, the Bank decided at its last fixed announcement date to maintain the target for the overnight rate at 1 per cent. The timing and direction of the next change to the policy rate will depend on how new information influences this balance of risks. As I noted at the outset, our inflation-targeting policy, combined with a floating exchange rate, has served us well for more than 20 years. Inflation targeting was designed against a backdrop of high inflation, but its key features of symmetry and flexibility also give us room to manoeuvre in an environment of disinflation. We are doing our best to identify the main drivers of disinflation and are continuously assessing their impact on the economy and their persistence. There is, of course, some uncertainty about our judgments, particularly as to how long increased competition will depress inflation. I can assure you that the Bank of Canada will continue to monitor developments closely, whether I am there or not. Thank you. S. Poloz, “Monetary Policy as Risk Management” (speech to the Canadian Club of Montreal, Montréal, QC, 12 December 2013). 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 BIS central bankers’ speeches
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, presented to the Victoria chapters of the Certified Management Accountants, Certified General Accountants and the Financial Management Institute, Victoria, British Columbia, 6 March 2014.
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John Murray: Stepping outside – analysing the Canadian economy from an international perspective Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, presented to the Victoria chapters of the Certified Management Accountants, Certified General Accountants and the Financial Management Institute, Victoria, British Columbia, 6 March 2014. * * * Accompanying charts can be found at the end of the speech. Introduction Good morning. Thank you for the invitation to address your workshop. One of my responsibilities as a Deputy Governor of the Bank of Canada is overseeing the Bank’s analysis of international economic developments. And before I became a Deputy Governor, I was Chief of the Bank’s International Department. So over the years, I have had the opportunity to study other economies and the policies of other governments and central banks in some detail. Looking at Canadian economic issues from an international perspective allows us to ask: How are we the same? How are we different? There is often a benefit to looking outward, examining developments beyond our borders as an aid to diagnosing and addressing suspected policy puzzles and problems at home. At the same time, we must be careful not to assume that what has happened elsewhere will necessarily happen here. Canada’s superior economic performance during the financial crisis and through the subsequent recovery, relative to that of most other advanced economies, was due in no small part to the Bank of Canada’s success in controlling inflation and the credibility that it has earned since 1991, when we adopted our inflation-targeting monetary policy (Chart 1 and Chart 2).1 Of course, other advantages, such as a resilient financial system and timely fiscal stimulus, also contributed importantly. However, I am not here to boast about our past successes. My purpose today is more immediate, and comes in three parts. I will begin by describing the two major macroeconomic challenges to sustainable economic growth that we are presently facing in Canada. Next, I will outline three analytic puzzles underlying those challenges, which we need to understand in order to formulate an appropriate monetary policy response. Finally, I want to demonstrate how information gleaned from the experiences of other countries can help answer these puzzles and guide the conduct of policy here. Two major macroeconomic challenges Economic activity in Canada has remained significantly below its potential level for some time (Chart 3), and the weak rates of inflation that have recently been observed are largely a reflection of this (Chart 4). The Bank’s first challenge, therefore, is to return inflation to the 2 per cent target jointly adopted by the Bank and the Government of Canada, and to return production in the real economy to its capacity level, since satisfying these two conditions generally goes hand-in-hand. Since 1995, the target has been to achieve an annual rate of total inflation of 2 per cent – the midpoint of a control range of 1 to 3 per cent – as measured by the consumer price index (CPI). The target is reviewed jointly with the federal government approximately every five years, and was last renewed in 2011. See Bank of Canada, “Renewal of the Inflation-Control Target: Background Information – November 2011.” BIS central bankers’ speeches Eliminating excess supply in the economy and returning inflation to target are not enough, however. The second challenge is unbalanced economic growth. The sources of growth must be well balanced for growth to be sustainable. A rapid return to potential is neither sufficient nor desirable, if it is only temporary and purchased at the cost of future instability and lower growth. What do I mean by unbalanced economic growth, you might ask? Why isn’t all growth, by whatever means, good? In today’s economy, a lack of balance implies growth that has relied too heavily on increases in household spending – in particular, the purchase of houses, with a resultant rapid increase in household debt. Future growth, if it is to last, needs to draw more support from business fixed investment and exports. During the depths of the last recession, demand for our exports collapsed, and extraordinarily accommodative monetary policy was needed to boost domestic demand in order to support employment and income (Chart 5). The Bank’s timely and aggressive policy actions – combined with extraordinary fiscal stimulus – worked, with extra internal demand effectively substituting for weak external demand. However, there are limits to how far this can be taken. The household sector is now largely played out; pushing it much further could lead to trouble. So we are left with an economy that in many respects has done well, but one in which both output and inflation are roughly 1 per cent below where they should be, and where the sources of demand need to be rotated.2 Macroeconomic puzzles The Bank’s base-case projection, as presented in our January Monetary Policy Report, has output returning to potential and inflation gradually returning to target in roughly two years. Setting the Bank’s overnight interest rate – the Bank’s primary monetary policy instrument – at the appropriate level over this period to achieve our objective always requires considerable judgement and must often balance more than one risk to the economy. Some of this uncertainty derives from not having a clear fix on where the economy is at present and what forces are acting on it. The output gap, for example, is not observable, and has to be estimated. But the challenge is more serious than simply not knowing exactly where the starting point is. Since monetary policy operates with long and variable lags, policy formulation must be forward-looking and anticipate the forces that might be acting on the economy one and two years out.3 The present situation is further complicated by three macroeconomic puzzles – the recent behaviour of three key variables and their implications for future economic performance. First, inflation has been unusually weak given the estimated size of the output gap and other identifiable forces thought to be putting downward pressure on prices. Second, fixed investment has been unusually weak given healthy corporate balance sheets, historically high profits, the low cost of capital and the growing momentum of the global recovery. In its January policy statement, the Bank noted that “Inflation in Canada has moved further below the 2 per cent target, owing largely to significant excess supply in the economy and heightened competition in the retail sector. The path for inflation is now expected to be lower than previously anticipated for most of the projection period. The Bank expects inflation to return to the 2 per cent target in about two years, as the effects of retail competition dissipate and excess capacity is absorbed.” (Monetary Policy Report Summary, January 2014.) And in its March 5 interest rate announcement, the Bank said that “with inflation expected to be well below target for some time, the downside risks to inflation remain important.” J. Murray, “Monetary Policy Decision Making at the Bank of Canada,” Bank of Canada Review (Autumn 2013): 1–9. BIS central bankers’ speeches Third, non-commodity exports have been unusually weak given strengthening global growth and somewhat improved competitive conditions. In other words, the macroeconomy has not been unfolding exactly as we had expected. The tendency in these situations is to view the puzzles as uniquely Canadian and to look for domestic explanations. Perhaps inflation is surprisingly weak because the output gap in Canada has been mismeasured: there might be more excess supply in the economy than the Bank has estimated. Perhaps exports are weak because Canadian firms are less competitive than originally thought, so exports are not rebounding as quickly as the growth in U.S. demand would suggest. Perhaps investment is weak because Canadian firms are inherently cautious and too conservative or because exports have underperformed. Looking inward for answers might be too limiting, however, and cause us to ignore helpful information elsewhere. Economic developments in Canada are often surprisingly similar to those observed in other countries. This is not simply because Canada is a small, open economy, and therefore subject to significant shocks originating in the global economy, although this no doubt accounts for much of the synchronous movement here and abroad. The similarity is also driven in many cases by more general global forces that are affecting several economies simultaneously, and that manifest themselves in Canada even when there are no obvious direct trade or investment links to these other countries. Alternatively, the similarity could be to events in another country that happened some time ago, which nevertheless bear a striking resemblance to our own situation, and are therefore instructive. Whatever the nature or source of these common patterns, they are potentially useful as a counterpoint to our own experience, an important and valuable lens through which to examine the Canadian condition. What I propose to do now, is to take each of the puzzles described above and show how looking outward has improved our understanding of what is happening within. The three puzzles from an international perspective Weak inflation The first thing to note about inflation is that it is weak across virtually all of the advanced economies. Canada is not alone. Indeed, inflation is well below the target levels in almost all advanced economies (Chart 6). It is not just the low level that is noteworthy, however. It is also the timing of the weakness. Most of the observed down-shift in inflation has occurred within the past two years. The significance of this will become apparent in a moment. In Canada, the weakness has been credited largely to continuing excess supply in the economy, which is putting downward pressure on wages and prices, and to an increase in competitive pressures in the retail sector. But, according to our best estimates, these factors are unable to explain the entire shortfall. Looking at inflation in other countries, one might be tempted to argue that there are global forces at work, and that inflation in Canada is not determined exclusively by domestic forces. In fact, statistical evidence gathered from something known as principal component analysis, which captures a common factor from various data sets, suggests that for total inflation as measured by the consumer price index (CPI) this is, to a degree, true. The high correlation one observes among rates of total CPI inflation in all of these countries is driven to an important degree by common movements in food and energy prices, which are known to be highly volatile and largely determined in world markets. This finding is not a surprise, but more a confirmation of something that was already known. BIS central bankers’ speeches The surprise relates more to the movements in core inflation, which also exert an important influence on total CPI inflation.4 While it is difficult to identify a common component using statistical techniques, they have moved in concert and have all shifted down quite recently. The existence of a sizable output gap in each of the countries could offer an explanation, but the timing is not right. These gaps have existed for several years, and, in some cases, have been narrowing (Chart 7). So why would inflation weaken now? It is possible that idiosyncratic developments, peculiar to each country, could explain the common pattern, but such an extreme coincidence seems unlikely. The more likely lesson that one might draw from this shared international experience is that the effect of output gaps on inflation is subject to a much longer lag than previously thought and that, to have an effect, the gaps must be not just large, but persistent. Indeed, the sensitivity of prices to excess supply might increase through time. This is not to preclude the possibility of other forces at work in Canada, such as an output gap that might be underestimated, just that the alternative explanation – a delayed response – must be given serious consideration. Provided this relationship holds, inflation can be expected to return to target as output returns to potential. Weak investment The story for “missing investment” in Canada is much the same. One can easily identify a number of homegrown factors that might be inhibiting business investment here (Chart 8 and Chart 9). Are Canadians risk-averse by nature? Are Canadian businesses too comfortable with what has worked in the past, and reluctant to strike out in new directions? Are there institutional or financial impediments that we are not aware of? Could weak investment be the result of the poor performance of our non-commodity exports since the end of 2011? Before answering yes to one or all of the above, it is important to note that businesses in other countries have also been accumulating cash balances and delaying fixed investments – in many instances reporting rates of investment that are much lower than the rates of depreciation, pushing the capital stock ever lower. “Dead money,” as it has been called, is not a uniquely Canadian phenomenon. Researchers in the United States have advanced an explanation based on their statistical work that is both intuitive and convincing.5 They have shown that uncertainty exerts a significant and distinct dampening effect on investment decisions, separate from other factors that might be closely related to it. Their results have been replicated by researchers elsewhere, and one can see a tight correspondence, if not causal relationship, between their measures of uncertainty and fixed investment activity. It would not be surprising if businesses were a little gun-shy and reluctant to commit large sums of money following the traumatizing experience of the crisis. The value of waiting for greater clarity is simply too high. Fortunately, the uncertainty appears to be receding, and there are signs that investment activity will accelerate in the near future. Weak exports The recent disappointment related to Canadian exports follows much the same pattern as inflation and investment, but with one or two notable differences. There has been a seeming disconnect between foreign demand and the performance of Canadian non-commodity exports over the past two years. The sectors of the U.S. economy that did especially badly in The Bank’s main measure of core inflation is CPIX, which strips out from total inflation eight of the most volatile components of the consumer price index as well as the impact of changes in indirect tax on the remaining components. S. Baker, N. Bloom and S. J. Davis, “Uncertainty and the Economy,” Policy Review 175 (2012): 3–13. BIS central bankers’ speeches the recession were those that were especially important to Canadian exporters. As these sectors recovered, our exports should have accelerated. But they didn’t. This disappointing performance is true even after one adjusts for the persistent strength of the Canadian dollar and the marked decline in our international competitiveness since the early 2000s. While it is possible that competitiveness or foreign demand, which the Bank proxies with a foreign activity measure (FAM), could have been mismeasured, sagging competitiveness seems to be a less obvious candidate.6 Neither the dollar, nor competitiveness defined more generally (i.e., in terms of productivity and wage gaps adjusted for the exchange rate), has shown any evident break in trend. Most of the export disappointment is specific to the past two years (Chart 10 and Chart 11). Interestingly, the growth in global trade collapsed at about the same time and even more dramatically than the fall-off in Canadian trade (Chart 12). Perhaps the weakness in Canadian exports has a common cause and we should be thankful for what we have. In this case, however, any race to judgment based on coincident timing could be misleading. Most of the reasons put forward for the collapse in global trade, such as constraints on the availability of trade financing and exceptionally weak economic activity in Europe, have little direct relevance for Canada.7 An alternative explanation has been put forward, however, that also has a foreign origin and holds a little more promise. It relates to the fiscal cliff in the United States and the significant budget consolidation that has been underway there in the past two years. Although one might assume that the demand for Canadian exports from U.S. governments (federal, state and local) would be minimal, preliminary evidence suggests that approximately 12 per cent of our non-commodity exports over the 1997 to 2012 period went to the U.S. government sector. Moreover, a modified version of the Bank’s foreign activity measure, which gives greater recognition to U.S government purchases, seems to improve our ability to capture the weakness in exports over the last two years. However, its explanatory power over the previous three years is not nearly as good. Work is ongoing, therefore, with a view to developing alternative measures of foreign activity which might perform better over the entire period. This provides a useful example of how the international perspective has the potential to mislead as well as inform. One possible connection proved to be a dead-end, while the other points to a possible answer. Correlation does not necessarily imply causation, but it helps us to flag events that might warrant further investigation. High household debt and housing sector activity Household debt and activity in the Canadian housing sector have also attracted considerable attention in the past few years. Unlike the three earlier examples – inflation, investment and exports – high household debt and housing sector activity do not necessarily represent a puzzle. However, they have reached historic highs and have been stronger and more resilient than many economists had expected. Household debt and housing sector activity are not only exceedingly elevated relative to past experience in Canada, they have also approached levels where real estate busts were observed in other countries. Charts 13 and 14 provide some international comparisons for two series that have attracted particular attention from international organizations (as well as The Economist magazine). The foreign activity measure is a trade-weighted index that aggregates the various sources of foreign demand, such as U.S. housing or fixed investment, and weights them according to their importance for Canadian exports. Of course, this does not preclude the existence of an indirect linkage between Canadian and European trade that might explain the weakness. BIS central bankers’ speeches These are the ratio of household-debt-to-disposable income and the ratio of average housing prices to disposable income. Needless to say, they have not gone unnoticed by the Bank of Canada either. The Bank has identified household debt and stretched housing evaluations as the most important domestic risks to financial stability in the country. It is important to stress that the figures in these charts represent national averages and vary across regions and types of accommodation. In some areas, they are much lower and in others, such as Vancouver and Victoria, they are much higher. Although countries such as the United States and the United Kingdom have experienced sharp and painful corrections at comparable debt and price levels, leading to much more serious economic and financial consequences, it would be a mistake to assume that a similar outcome is therefore inevitable in Canada. The Bank’s base-case projection sees household debt, housing prices and housing starts levelling off and then gradually declining (in real terms, in the case of housing prices): in other words, achieving a soft landing. Recent data, such as decelerating monthly price increases for existing homes, a declining number of housing starts and historically low rates of household credit growth, all support this view and indicate that the situation is stabilizing, although the risks remain elevated. International evidence also provides some support for this more benign scenario. Countries such as Australia have managed a soft landing and the preconditions for this, one could argue, are even more favourable in Canada. Higher mortgage underwriting standards, higher home equity margins, historically low debt-servicing costs, a more resilient banking sector and a number of pre-emptive macro-prudential measures that have been undertaken, in the form of tighter mortgage insurance and mortgage-lending standards, all work in this direction. Indeed, credit quality in Canada has been increasing even as credit continues to expand. In this instance, the international perspective illuminates the downside and the upside. It highlights the risks that might be realized if the situation is not well managed, but it also provides evidence that a more positive outcome is possible – and indeed more likely. Close monitoring is nevertheless required to help ensure that this cautionary tale does not become a reality. Conclusion The global economy and the experiences of other countries provide a sort of natural experiment through which we can better assess economic developments in Canada. In many cases, the economic cycles of other countries are either moving in step with ours or have preceded them. Often, this will be because events elsewhere are shaping events in Canada; at other times it may be mere happenstance or the result of some more general force hitting us and others in a synchronous manner. An international perspective can provide both understanding and policy insights. While it is important to interpret with caution what you see through the international lens, we have seen how it can help us resolve domestic economic puzzles and guide policy. With regard to inflation, fixed investment, exports and the household sector, it has also pointed the way to more positive outcomes and supported the base-case projections of the Bank. The international perspective deepens our understanding of how the Canadian economy works and gives us greater confidence in how our policy actions influence the ultimate outcomes. Economic developments in Canada are not predetermined by events outside our borders. Domestic factors are important and we are ultimately the masters of our own destiny. The international perspective simply allows us to conduct our affairs in a more informed way, and improves the odds of a favourable outcome. 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 Stephen S Poloz, Governor of the Bank of Canada, to the Halifax Chamber of Commerce, Halifax, Nova Scotia, 18 March 2014.
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Stephen S Poloz: Redefining the limits to growth Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Halifax Chamber of Commerce, Halifax, Nova Scotia, 18 March 2014. * * * Introduction Happy belated St. Patrick’s Day. I hope everyone’s feeling fine. I want to speak today about a different kind of headache: the prolonged lacklustre economic growth we are experiencing, here in Canada, but also globally. Canada’s economy has been in recovery since 2009 – for four years – yet economic growth still pales compared to the pre-crisis years. Likewise, the global economy has been growing, on average, at only about two-thirds the pace of growth in the four years prior to the crisis. You’re right if you think it’s unusual to have such weak growth in a recovery. It is also unusual to have weak growth for such a prolonged period of time. You might well be asking: So, what are we in for? What can we plan on? There are different ways of looking at this. Some suggest it is the tail end of the crisis that is still limiting growth, while others propose that we are facing a slower long-term trend. In short, there are two responses: on the one hand, the cheque is in the mail; and, on the other, this is as good as it gets. The real answer is: It’s complicated. Both views are part of the story. In the time I have with you today, I’d like to talk about the forces that are holding back economic growth in Canada and the world. My hope is that you will take away some insights into the Bank’s analysis of what we are experiencing – so that you can make reasonable, informed financial decisions for yourselves and your families, your businesses, and your futures. The global financial crisis Let’s start with the financial crisis. As a global event, it has drawn a lot of attention, rightly so. In very short order, global GDP fell by more than 3 per cent and millions of jobs were lost. Here in Canada, almost a half million jobs were lost and GDP fell by more than 4 per cent. The policy response around the world was rapid and extraordinary. Policy interest rates were slashed to near-zero in many advanced countries; the economies at the centre of the crisis further eased monetary conditions through quantitative easing. The G-20 countries also undertook an unprecedented and concerted fiscal expansion. These policies worked well, no doubt about that. No matter how you feel about the final outcome, we all recognize that it could have been far worse – indeed, that coordinated policy response may have averted a full-blown global depression. Nevertheless, given the passage of time, it is reasonable to ask why growth has not yet returned to pre-crisis trends. One widely accepted explanation is that, historically, a recovery following a financial crisis has always taken longer than a recovery in a more normal business cycle. According to this view, a period of subdued growth after a financial crisis can still be regarded as cyclical, in the sense that it will eventually prove to be temporary. Once balance sheets have been repaired, growth should return to its historical trend – bearing in mind that growth in the United States, and much of the rest of world, leading up to the crisis was extraordinary, so the true historical trend precedes that period. Still, given the uncertain timing, this approach reminds me of that old excuse, “Sorry, but the cheque is in the mail.” BIS central bankers’ speeches More than a hangover But the global economy may not be just suffering through a hangover from the financial crisis. There are other, longer-term forces at work as well. Some analysts are suggesting we may be facing a long period of secular stagnation. On this alternative view, the economy could perform well below normal, leaving many out of work or underemployed for a long time to come. As business people, you need to understand that possibility, and how much weight to put on it. As a central banker, I need to understand it as well. Let’s dive in. Long-term economic growth is driven by two factors: 1) growth in the supply of labour, which is connected to population growth and changes in its composition, or what we call “demographics;” and 2) productivity growth, which is economists’ shorthand for how efficiently we produce goods and services. For illustration, if we had 2 per cent trend growth in the supply of labour and 1 per cent trend growth in productivity, trend growth for the economy would be about 3 per cent. Now, productivity is fodder for a speech all on its own, which I won’t impose on you. Let me quickly summarize how it fits in before expanding on the demographic forces at work. Productivity growth fluctuates around a long-term trend, tending to be weak during recessions and the early stages of a recovery, and stronger in periods of economic expansion. It follows then that the weakness in productivity growth since the financial crisis may be a symptom of a post-crisis hangover. Indeed, in Canada, the latest data show a pickup in productivity in the second half of 2013, to around 2 per cent, which is very promising. The Bank’s outlook for the next couple of years is that uncertainty will continue to dissipate, boosting investment and new firm creation, and then productivity growth is expected to outpace its 30-year average. A demographics story The other ingredient of Canada’s potential economic growth is the labour force. So let’s turn to demographics and start with one immovable fact and one quick reminder. First, we are all getting older each day; and second, the baby-boom generation – yes, I am among them – is Canada’s largest population cohort. The demographics story is often told as one about the labour force: as the boomer generation retires and exits from the workforce, labour’s contribution to the potential growth of the economy declines. This is already under way. In 2011, the growth rate of the population of working-age Canadians crossed below that of the overall population, reversing an almost 50-year trend. The Bank expects that next year, labour’s contribution to the potential growth of the economy will be half what it was in 2007. That’s the labour story, in a nutshell, and it is slowing us down. There’s another dimension to the demographics story – one that gets less attention, but that merits careful consideration to fully understand what the future holds. As people move through different stages of life, their spending and savings habits change. Think of the students out there who are amassing university or college loans. A bit later on, people enter a family-building stage, which normally involves some heavy borrowing up front for a family home. As we get older, we tend to take a breather on the accumulation of debt; we work at paying it back and start to put aside savings. As we get closer to retirement, people save more and build up wealth. Typically, in the 15 or 20 or so years before they retire, people are in serious nest-building mode. As the facts show it, Canadian households are indeed getting wealthier, which is a good thing. Data released last month show that, despite the financial crisis and Great Recession, net worth rose noticeably across all age groups from 1999 through 2012. Now, let’s bring the boomers into the picture. They’re called the boomers for a reason. The huge wave of that generation simply overwhelms the charts. Born between 1946 and 1964, BIS central bankers’ speeches the youngest boomers are turning 50 this year. And so, right now, we are seeing a very predictable demographic bulge of more people, putting away more savings. This is Mother Nature at work, and it’s where things get interesting. Why does a central banker care? First, the financial decisions made by individuals are of course important to those individuals. But when a large swath of the population is making similar decisions, the impact on the broader economy can be significant. Second, where individuals decide to store their wealth also matters a great deal. Allocation matters Canadians, it won’t surprise you, love their houses. We hold a lot of our wealth in real estate. This practice preceded the crisis, and it was reinforced by it. You may recall – it even may have been your experience – in the 1990s, the share of household wealth in financial assets, such as equities, was increasing faster than that in real estate. But since then, real estate has become more attractive and has grown as a share of total household assets. With the “dot-com” bust and Enron and other corporate scandals in the rear-view mirror, with low interest rates helping keep mortgage payments manageable, and with cocooning taking hold, housing was increasingly seen as a safe and attractive investment. For the sector as a whole, real estate assets accounted for 40 per cent of total wealth in 2012, up quite a bit from 32 per cent in 1999. Economists have their own way of interpreting these trends. We see some forms of assets primarily as “stores of value,” while others work through the system to fund investments and add to the productive potential of the economy. Savings that fund infrastructure and business investment are “being put to work,” which can help improve productivity, while savings that go into housing are seen as contributing less to productive potential. This shift toward housing was also evident in many developed countries before the crisis hit and could have contributed to a slower growth rate for productivity. Layering on the crisis Importantly, the fallout from the financial crisis has worked to magnify some of these effects. It’s only logical to expect that secular trends and cyclical fluctuations interact with each other – and this is certainly true of the demographics-savings trend and the crisis. As I mentioned, the crisis walloped global demand. It opened up a huge and persistent uncertainty wedge that has held down global demand for business fixed investment. In many countries, the crisis also triggered household and bank deleveraging, not to mention fiscal consolidation. As a result, there has been a crisis-induced increase in savings at a global level. There already was a demographics-driven desire for higher savings in advanced economies and there were massive savings inflows from emerging markets. Then, through widespread deleveraging, the crisis added an extra boost to the world’s aggregate savings. Naturally, this translates into weak aggregate demand. As a trade-dependent economy, Canada feels these effects directly. Weak global demand is limiting the growth of our exports, and the associated uncertainty is holding back business investment in structures, equipment and software. In other words, demographic forces and the lingering hangover from the financial crisis are pulling in the same direction, putting limits on our growth possibilities. BIS central bankers’ speeches Policy response and the outlook for growth I’ve slowly come around to answering my own question about why this matters to a central banker. It’s not just because we care – which, let me assure you, we do. But in order for us to do our job properly, we need to understand all the dynamics that feed into the Canadian economy – and, importantly, how our own policy measures affect the outcomes. In Canada, low policy rates motivated Canadians to invest even more in real estate. You could say the Canadian recovery was due to the reinforcing of activity that was already under way, thanks to underlying demographic forces. But we know that we cannot sustain economic growth in Canada based on housing alone. Our belief is that the post-crisis hangover in the United States is dissipating, and momentum is building. This will inevitably lead to more growth in Canadian exports and, with the reduction in uncertainty that comes with that, more investment in Canada’s economic capacity, including creating more companies – and the much-anticipated rotation in growth. This won’t necessarily happen in a linear fashion. Although we continue to expect abovetrend growth in Canada this year and next, the recent data suggest that the first quarter will be on the soft side. This mostly seems to be attributable to unusual weather, but it bears deeper analysis. Similarly, on the inflation front, while we have had a couple of months of slightly stronger core inflation, which is reassuring, most analysts are expecting softer inflation data later this week because of a sharp movement in February last year. Looking through the short-term volatility, inflation still seems to be running at around 1.2 per cent, give or take a tenth or two. While we expect growth to approach 2.5 per cent over the next couple of years, we also see the economy’s potential capacity growing at around an average of 2 per cent. This is why we say that it will take a couple of years for us to close our excess capacity gap and get inflation back to near our 2 per cent target. Looking beyond that, one would normally expect our economy to grow at its potential, which, as I said, is around 2 per cent, and which is made up of about 1 to 1.5 per cent growth in productivity and a gradually declining contribution from labour force growth, driven by the demographics story I outlined earlier. Accordingly, were it not for our demographic outlook, our growth would converge on a higher trend line. This is the sense in which demographic forces help define our limits to growth. In the broader global economy, however, the possibility of secular stagnation needs to be taken seriously. The combination of low demand, low investment and high savings could be having an impact on what economists refer to as the Wicksellian rate, or the equilibrium real rate of interest. There is rigorous theory behind this notion, which I will spare you, but it suggests that interest rates may remain lower than we have experienced in the past for a longer period, until some of these long-term forces dissipate. One specific consequence would be that even extraordinarily low policy interest rates could prove to be less stimulative than in normal circumstances. Cause for optimism In the G-20 meetings held recently in Sydney, Australia, we recognized that the global economy has not yet returned to strong, sustainable and balanced growth, and that there is limited scope for further stimulus from conventional policies. It was in this context that we underscored the importance of structural reforms to future growth. To make this notion concrete, the G-20 set out an aspiration to collectively boost global GDP by 2 per cent over the next five years, or about 0.4 per cent per year in growth terms, on average. Maybe this does not sound like much, but it would add up to US$2 trillion for the world. That’s a lot of income, especially when it would arrive more or less for free – it would come from countries removing structural impediments to growth. BIS central bankers’ speeches Such impediments include trade barriers, labour market rigidities and other factors that make economies inefficient. If your car has an issue that is preventing it from running at top speed or top efficiency, you either arrive late or waste a lot of fuel getting there. Economies are the same – structural impediments impose limits to growth, and removing them can redefine our limits to growth. The goal of raising global GDP by an extra 2 per cent over the next five years is a reasonable aspiration, and Canada certainly shares it. As a small open economy, we have the opportunity to garner more growth from abroad by building our international businesses. There are lots of economies growing faster than ours, and we can position ourselves to catch those tailwinds, which will help us overcome some of the domestic demographic constraints on demand. We can do this now, but as our various free trade agreements fall into place, we will be able to do so even more effectively. As our exports strengthen and confidence improves, increased business investment and the creation of brand new companies will help raise our productivity and counterbalance some of the demographic constraints on labour supply. Other structural changes can also contribute in this way, including improving competitiveness; removing barriers to interprovincial trade and the migration of workers; and increasing investments in education, training and infrastructure, to name a few. The effect of any of these structural changes is win-win-win: companies win, because they can plan better and grow their business; consumers win, in the form of employment growth and reduced uncertainty; and governments win, as higher growth automatically makes fiscal planning easier. Raising our trend growth rate by only 0.1 or 0.2 percentage points per year through such structural reforms would mean an income boost of $25,000 to $50,000 over a typical 30-year career – certainly worth having. Conclusion Let me wrap up. Over 40 years ago, the Club of Rome published a book entitled, The Limits to Growth. To the global think tank, those limits were about finite natural resources and the environment. Although the timing remains uncertain, its arguments remain relevant today. But within that envelope, we have the ability to define our own limits to growth. The financial crisis was nearly calamitous, and we are still working to overcome its after-effects with both macroeconomic policies and a new global financial architecture. We continue to believe that the world economy is healing, and that Canada will benefit in the form of stronger exports. From there, we expect to see more investment and new firm creation. This will permit the emergence of a natural, sustained growth trajectory for Canada, and a return of inflation to our 2 per cent target. But the demographic forces that are in play suggest that the growth trajectory that we converge on after the recovery period will be slower than our historical trend, and it will also be associated with lower equilibrium rates of interest than we are used to. Fortunately, global policy-makers have the ability to redefine the limits to growth by removing growth impediments, but as business people and investors, we must keep those efforts in perspective. The world remains a complicated place, and there may be implications for your businesses and your personal savings and investment plans. I hope I have been able to add to your understanding today. BIS central bankers’ speeches
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Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Osgoode Hall Law School and Schulich School of Business, Toronto, Ontario, 24 March 2014.
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Timothy Lane: Financial benchmarks – a question of trust Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Osgoode Hall Law School and Schulich School of Business, Toronto, Ontario, 24 March 2014. * * * Thank you for the opportunity to speak to you today on a subject that has been at the centre of much attention recently. This city, like all others, depends on trade and commerce to thrive. At the root of successful trading and commercial relationships is the trust that each party to a transaction will deliver what was agreed. Many institutions have been developed throughout history to support that trust. Among the most basic of these are standardized units of measurement. More broadly, that trust is founded on the rule of law and other elements of good governance. Trust is also of fundamental importance to the world of finance. That trust has been shaken recently by a series of headlines related to financial benchmarks such as the London Interbank Offered Rate, or LIBOR. Today, I will discuss why we use financial benchmarks, how we use them, why they have been in the headlines and what we are doing to re-establish the trust that is so vital to a wellfunctioning financial system. What are financial benchmarks? Financial benchmarks are used in a variety of contracts to specify what, or how much money, is to be delivered on particular dates. One example is floating-rate debt, where the borrower pays the lender an amount of interest based on a benchmark that varies from one period to another according to a selected measure of interest rates. Benchmarks are also particularly important for derivatives such as interest rate swaps, which are critical tools of risk management. When benchmarks function as they should, they are a straightforward and technical element in the world of finance. They are intended to provide an unbiased, arm’s-length measure of underlying market prices. What went wrong? But some financial benchmarks have recently made headlines – for the wrong reasons. These benchmarks include LIBOR and some foreign exchange rate benchmarks (commonly known as “FX fixes”). As alleged misconduct related to such benchmarks has been investigated, firms have paid multi-billion-dollar fines, and some high-flying traders have lost their jobs. These headlines have been damaging to trust. They raise doubt about whether some key financial benchmarks were in fact providing an unbiased, arm’s-length measure of actual market conditions. At the extreme, they could even be seen as raising questions about the integrity of the wider financial system. Let’s look at the problems that have arisen. LIBOR First, let’s take LIBOR. LIBOR emerged as the eurodollar markets developed in London in the late 1960s and 1970s. In particular, it was developed in response to the rise in the syndicated eurodollar loan market and demand for tools to manage risk exposures, including those that arose from BIS central bankers’ speeches making those loans. These tools, known today as interest rate derivatives, needed a common benchmark so that they could be commoditized more easily, and LIBOR was this common rate. LIBOR was first officially published on New Year’s Day in 1986. As an interest rate benchmark, LIBOR is used as a measure of prevailing interest rates in a range of major currencies for maturities from overnight to one year. And, although originating in loan markets, it has come to be the dominant benchmark in a wide range of cash and derivatives markets. LIBOR – and its equivalents in some other currencies, collectively known as “IBORs” (interbank offered rates) – is used to determine the floating rate paid on over US$500 trillion dollars of interest rate derivatives contracts, as well as many trillions in floating-rate loans and securities. LIBOR is calculated based on submissions from a panel of banks: each bank is responsible for estimating the cost at which it could borrow in the unsecured interbank market from other banks, at various maturities and in various currencies. LIBOR is calculated as an average of these estimates, after dropping the highest and lowest figures. Banks’ individual quotes are also made public – to deter anyone from submitting a wild number to influence the average. The important thing to remember about LIBOR is that not every submission is based directly on actual transactions. For example, during the global financial crisis in 2008, when the interbank market essentially dried up, especially at longer maturities, banks still had to contribute to the benchmark. Now let me turn to the problems that have emerged regarding LIBOR. The first is signalling. In circumstances such as those during the height of the recent crisis, when interbank credit conditions were becoming increasingly difficult, a bank could become reluctant to report higher estimates than its peers for fear this would be interpreted as a signal that its own creditworthiness was deteriorating. The second problem is manipulation, the stuff of most of the headlines. The focus has been on LIBOR survey responses at some individual firms being biased, with a view to profiting on trading positions. Of course, to the extent that this kind of misrepresentation occurred, it is criminal behaviour and the authorities have been treating it as such. Foreign exchange fixes Now let me move to foreign exchange benchmarks. Foreign exchange benchmarks are typically calculated from actual spot trades over a short predetermined time period (or “window”) each day. It has been alleged that foreign exchange traders at some large financial institutions exchanged information about their clients’ orders with a view to positioning themselves advantageously in the market. The suspicion of such collusion – as suggested by some emails and chat-room discussions that have come to light – is being taken very seriously. The existence of collusion cannot be inferred, though, from the volume of trading during the fixing window. Banks may want to execute many of their own trades during the fixing window, for instance, because their customers want to transact at the fixing price, and banks therefore look to offset those positions around the fix so as to manage their market risk. Issues relating to how fixes are designed, and how they are used by banks and their customers, are now being examined by global authorities. What should be done? To address some of the problems associated with benchmarks, two options present themselves: reform or replacement. We can reform existing benchmarks to strengthen governance and enforce procedures that provide adequate checks against conflicts of interest and collusion. Or, we can replace them with more robust alternative benchmarks. In BIS central bankers’ speeches fact, it is likely that neither of these solutions will be sufficient by itself. We will need to do some of both. Reforming benchmarks The first step in reforming benchmarks is clarifying governance. Who has direct responsibility for setting those benchmarks and assuring their integrity? What kind of governance exists within the financial institutions that determine the benchmarks? And who oversees those processes to make sure that the safeguards are appropriate? Last summer a group of financial market regulators from around the world, the International Organization of Securities Commissions (IOSCO), released its Principles for Financial Benchmarks – a set of best practices aimed at answering these questions. These principles outline a framework for the governance and administration of financial benchmarks, including the roles, responsibilities and internal controls required of a benchmark’s administrator. Attention is paid to the additional controls necessary for survey-based benchmarks, which have been a particular cause of concern. Replacing benchmarks The second option, replacing existing benchmarks with new ones, is challenging for two reasons. First, it may be difficult to find a superior alternative benchmark, which is robust and also captures the relevant economic exposures. Second, even if a suitable alternative can be identified, making the transition may not be a straightforward matter. The IOSCO principles outline desirable features for robust financial benchmarks. Notably, they call for benchmarks to be anchored to observable transactions in active underlying markets. One could consider going further: relying only on actual market prices as benchmarks. Indeed, there are some cases – for instance, short-term repo markets – in which underlying markets are sufficiently liquid to reliably support benchmarks that are simply averages of the rates at which participants transact. In other cases, market prices could at least be used as a cross-check against a survey-based measure, even when they cannot be used directly to calculate the benchmark. In other cases, it may be hard to find a suitable market price that tracks the desired aspects of market conditions. If a replacement benchmark does not fully reflect the economic exposures that are being hedged, the hedgers will not be able to manage their risks as effectively. Moreover, in the absence of appropriate governance, controls and regulation, market prices can also be subject to manipulation. Benchmarks derived solely from transactions also face the challenge of how to determine the benchmark rate should there be no transactions in the relevant market on a particular day, or indeed over a whole series of days – for example during periods of stress. Even if a superior alternative benchmark could be found for some markets, several issues would need to be addressed before making a switch. Existing benchmarks are already written into an enormous number of contracts, some of which could still have years, if not decades, to run. These contracts would have to be closed out and/or rewritten, which raises issues of coordination and of legal risk. Taking these concerns into account, last year the Financial Stability Board (FSB) established a steering group of regulators and central banks to help coordinate upcoming reviews of existing benchmarks against IOSCO’s standards and to examine the feasibility of developing alternative benchmarks, at least for some markets. The main focus is on the major global interest rate benchmarks: LIBOR, the Euro Interbank Offered Rate (EURIBOR) and the Tokyo Interbank Offered Rate (TIBOR). This steering group has been working with market participants from around the world to evaluate possible BIS central bankers’ speeches alternative benchmarks and to identify and look at ways of mitigating any issues that might arise during the transition. When this work is complete, its findings will help inform views as to possible alternative financial benchmarks in other currencies, including the Canadian dollar. Similar international work has recently been launched to examine foreign exchange benchmarks. CDOR – A Canadian case Moving closer to home, the main benchmark for Canadian-dollar interest rates is the Canadian Dealer Offered Rate (commonly known as CDOR). It is used to determine interest payments on Can$130 billion in floating-rate notes and payments on about US$9.3 trillion in Canadian-dollar interest rate swaps1 as well as over Can$750 billion in exchange-traded derivatives. Given CDOR’s importance, making sure it is robust is essential to the whole Canadian financial system. So where does CDOR come from? CDOR is the rate at which banks are willing to offer credit to companies against bankers’ acceptances (BAs). CDOR is determined through a daily survey of seven market participants held at 10:15 every morning. In a simple process, the highest and lowest rates are dropped and the final five rates are averaged. While the number of banks in the panel may look small, they represent the key players in the BA market, originating close to 99 per cent of the approximately Can$67 billion in outstanding BAs in Canada. Thus, although CDOR has some similarities to LIBOR, they are different animals. CDOR is a bank lending rate, rather than a bank borrowing rate. Another difference is that while it is not an average of secondary market transaction data, it is derived from an underlying market that remains sizeable. This is in contrast to some unsecured interbank markets, the basis of LIBOR, which have generally shrunk substantially since before the crisis. Also, since banks are committed to lending to companies with BA lines based on CDOR, and because borrowers choose when and at what maturity to borrow, it is less likely that these rates would be subject to the problems I discussed earlier. These features of CDOR do provide some reassurance – and indeed, no problems similar to those with other financial benchmarks have been reported. Nonetheless, given the vital role that CDOR plays in our financial system, Canadian authorities judged it essential to examine CDOR more closely in light of the new IOSCO principles and the experience with interest rate benchmarks elsewhere. Strengthening the governance of CDOR In 2012–13, as an initial step toward strengthening the governance of CDOR, the Investment Industry Regulatory Organization of Canada (IIROC) reviewed existing practices. The focus of this review was on the panel members’ supervisory practices: specifically, how CDOR submissions are calculated, who participates, who supervises, and who has regulatory jurisdiction. It was not intended to be an investigation into potential wrongdoing or manipulation of CDOR. The IIROC review noted some inconsistencies in procedures among different institutions, and a failure in some cases to document those procedures. IIROC also identified a need to strengthen independent compliance oversight of rate setting to complement business supervision procedures and conflict-of-interest protocols within institutions. Action is now underway, both by the official community and industry, to address the issues highlighted in the review. Given that CDOR is based on banks’ issuance of BAs, and with Bank for International Settlements, Triennial Central Bank Survey, “Statistical Release, OTC Derivatives Statistics at End-June 2013,” November 2013. BIS central bankers’ speeches CDOR submissions now coming entirely from banks rather than dealers, the relevant authorities have agreed that banks’ CDOR submission processes are most appropriately regulated by the banks’ regulator, the Office of the Superintendent of Financial Institutions (OSFI). Accordingly, in January, OSFI announced that, consistent with its mandate and expertise, it will supervise the effectiveness of governance and risk controls surrounding banks’ CDOR submission processes.2 Subsequently, in its recent budget, the federal government announced its intention to include a regulation-making authority in the Bank Act covering bank submissions to financial benchmarks. Furthermore, the banks on the CDOR panel should, fairly soon, release a submitters’ code of conduct that they have developed in consultation with IIROC and the Bank of Canada. In addition to providing a formal definition of CDOR and requirements for being a submitter, the code will specify minimum standards for submission methodology, internal oversight and records retention. Work continues to strengthen other aspects of the governance of CDOR to meet the principles established by IOSCO. For instance, we have discussed with industry the need for it to establish more formal administrative arrangements for CDOR, and the industry has begun work to take this forward. Other Canadian benchmarks While CDOR is probably the most important financial market benchmark in Canada, it will also be important to ensure that other significant benchmarks are well designed and have appropriate governance, in line with IOSCO standards. One obvious example here is the Canadian Overnight Repo Rate Average (CORRA). Although less widely used than CDOR, CORRA is important for the Canadian financial system, since it is the reference rate for overnight index swaps, which is a sizable derivatives market. CORRA is calculated based on actual transactions in the overnight market.3 Although not owned by the Bank of Canada, we calculate and publish the rate on the basis of data submitted by the brokers. Work has begun to look at what changes may be needed to CORRA given the new IOSCO standards. I expect that, as it progresses, that work will need involvement from a range of stakeholders. Turning to foreign exchange rates, while the Bank of Canada posts indicative exchange rates based on market transactions and market quotes, it does so for information purposes, not as a benchmark. Nevertheless, these rates seem to be used as benchmarks for some financial transactions. While there is no evidence of market manipulation affecting the Bank of Canada’s rates, we are reviewing these rates and considering any changes that may be appropriate. We will examine how these posted rates are currently used by market participants to see how any possible changes could affect market functioning. Conclusion We’ve covered some technical ground, but the basic thrust is simple. We need good governance to maintain trust in the myriad financial contracts on which our economy is built. See Office of the Superintendent of Financial Institutions, “Oversight of CDOR Benchmark-Setting Submissions,” 13 January 2014. Specifically, it is a weighted average of general collateral repo trades that take place daily through three interdealer-brokers. BIS central bankers’ speeches I’ve talked about how some key financial benchmarks in other jurisdictions have fallen short of these requirements and what is being done to rebuild trust, internationally and in Canada. The introduction and implementation of the IOSCO benchmark principles will help ensure greater integrity and governance for financial benchmarks. Here at home, better articulated governance arrangements for CDOR and other important financial benchmarks will contribute to greater financial stability. In that context, robust financial benchmarks are akin to reliable units of weights and measures. Whether it is a litre of wine, a pound of butter or an interest rate benchmark, there should be no question that measurements for commercial and financial transactions are accurate and fair. BIS central bankers’ speeches
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Opening statement (via video) by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Toronto, Ontario, 16 April 2014.
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Stephen S Poloz: Summary of the latest Monetary Policy Report Opening statement (via video) by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Toronto, Ontario, 16 April 2014. * * * Good morning. Tiff and I are pleased to join you today by videoconference. As you know, we are in Toronto to attend the funeral this afternoon of Canada’s former Finance Minister, Jim Flaherty. Before we discuss the Monetary Policy Report, I’d like to say a few words about him. What set Jim Flaherty apart was that while he was a formidable Finance Minister, he was first and foremost an ordinary man. You immediately connected to him after just a few minutes, and it was immediately clear that he was there for Canada, 100 per cent. That’s what he did all day, every day. And to everything that he did, he brought a solid dose of common sense. People found that attractive and helpful, and his gut instincts were usually right. A lot of his legacy is right there for us. I’ll miss him tremendously, and Canada is the poorer without him. Let me turn now to the MPR, which the Bank published this morning. Before we take your questions, allow me to note its highlights. • Inflation in Canada remains low. Core inflation is expected to stay well below our 2 per cent target this year and it will take close to two years for it to return to the target. Total CPI inflation is expected to move closer to the target in the coming quarters due to temporary factors. • Let me take a moment to explain this inflation forecast. Core inflation is expected to remain below target due to the effects of economic slack and heightened retail competition. We expect these effects to persist until early 2016. • However, total CPI inflation will move up this year, before core, in response to higher consumer energy prices, as well as the lower Canadian dollar. • We expect total CPI inflation will remain fairly close to target throughout the projection period. That’s because in 2015 and into early 2016, as the upward pressure from energy prices dissipates, the downward pressure from retail competition should gradually fade and excess capacity will be falling. This will cause core inflation to make its way gradually up to 2 per cent, catching up to total CPI inflation from below. • The global economic expansion is expected to strengthen over the next three years as headwinds that have been restraining activity dissipate. • The economic recovery in the United States appears to be on track, despite soft readings in the last few months largely due to unusual weather. Indeed, private demand could turn out to be stronger than anticipated. • Europe’s economy is growing modestly, but inflation remains too low and the nascent recovery could be undermined by risks emanating from the Russia-Ukraine situation. • In China and other emerging-market economies growth is expected to be solid, although there are growing concerns about financial vulnerabilities. • Overall, global growth is expected to pick up to 3.3 per cent in 2014 and increase further to 3.7 per cent in 2015 and 2016 – largely unchanged from January. BIS central bankers’ speeches • The Bank continues to expect Canada’s real GDP growth to average about 2 1/2 per cent in 2014 and 2015 before easing to around the 2 per cent growth rate of the economy’s potential in 2016. • Competitiveness challenges continue to weigh on Canadian exporters’ ability to benefit from stronger growth abroad. • As an open economy, the performance of Canada’s export sector is critical. Given the growing wedge between Canada’s exports and foreign demand, the Bank has deepened its analysis of this sector. Our research has broken down the export sector into a large number of subsectors and we are discovering that there is a range of subsectors for which exports have been in line with the fundamentals – or better. • This suggests that as the U.S. recovery gathers momentum and becomes more broadly-based, many of our exports will benefit. The lower Canadian dollar should provide additional support and we can be more confident about our recovery in these subsectors. • Other subsectors are experiencing greater competitiveness challenges and, for them, the wedge remains. The recovery for these groups will be slower, even as they are helped by the lower exchange rate for the Canadian dollar. • This analysis provides a more granular interpretation of the export picture. Overall, we expect a gradual convergence between the growth rate of Canada’s exports and that of the U.S. economy. But this implies some of the wedge between exports and foreign demand will be very persistent. • Further, we continue to believe that rising global demand for Canadian goods and services, combined with the assumed high level of oil prices, will stimulate business investment in Canada and shift the economy to a more sustainable growth track. • Recent developments are in line with the Bank’s expectation of a soft landing in the housing market and stabilizing debt-to-income ratios for households. Still, household imbalances remain elevated and would pose a significant risk should economic conditions deteriorate. • In sum, the Bank continues to see a gradual strengthening in the fundamental drivers of growth and inflation in Canada. This view hinges critically on the projected upturn in exports and investment. With underlying inflation expected to remain below target for some time, the downside risks to inflation remain important. At the same time, the risks associated with household imbalances remain elevated. • The Bank judges that the balance of these risks remains within the zone for which the current stance of monetary policy is appropriate and therefore has decided to maintain the target for the overnight rate at 1 per cent. The timing and direction of the next change to the policy rate will depend on how new information influences the balance of risks. With that, Tiff and I would be pleased to take your questions. BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Saskatchewan Trade and Export Partnership, Saskatoon, Saskatchewan, 24 April 2014.
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Stephen S Poloz: Canada’s hot – and not – economy Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Saskatchewan Trade and Export Partnership, Saskatoon, Saskatchewan, 24 April 2014. * * * Introduction Thank you for that kind introduction, and thank you to all of you for coming today. It’s my pleasure to be here with the Saskatchewan Trade and Export Partnership. I applaud your efforts to develop exports from this province to the rest of the world – Canada’s economy needs those exports. From my vantage point at the Bank of Canada, I take a broad view of the Canadian economy as a whole. But, depending on where you work or where you live, your sense of how well the economy is doing will vary. From one region of Canada to another, from one sector of the economy to another, we are seeing fundamental differences in the demand for our products, in employment, in wages and in housing. In fact, we are seeing markedly different rates of economic growth. Some sectors and some regions are hot – and some are not. This shows up most tangibly in employment and housing. In places like Fort McMurray, it’s fairly easy to find a job, but hard to find a place to live. In other cities, the reverse is true. In the time I have with you today, I’d like to talk about what’s hot and what’s not – and the forces fuelling the economy’s heating and cooling systems. My job today is to pass on some of the Bank’s analysis so that you can use it to make informed financial and economic decisions for yourselves and your families, your businesses, and your futures. What’s hot? Oil One of the most important forces powering Canada’s economy today is the long-term strength in global prices for resources. For Canada, oil stands out. We have the world’s thirdlargest reserves of crude oil. And we’re number one in potash production. This means money in our pockets. In technical terms, it is a positive terms-of-trade shock. In non-technical terms, it’s a gift. As the value of the resources we export goes up, and as the value of the products we import either remains low or rises more slowly – or, as our terms of trade improve – more wealth flows to Canadians. Let me put it this way. You’ve got a box of old hockey cards in the basement, right? Everybody does. What if in that box you’ve got a Chris Kunitz card from his rookie days? Hey, now that the Regina native is an Olympic gold medallist and two-time Stanley Cup winner, that card is suddenly worth a lot – and you have the incentive you need to go dig it out of the basement. It’s the same thing with a terms-of-trade shock. Since 2002, we have enjoyed the benefit of an almost 25 per cent rise in Canada’s terms of trade. With the average world price of oil over the past decade more than double that of the previous three decades, Canada’s resources are suddenly worth a lot – and we have the incentive we need to go dig them out of the ground. That’s what’s been happening. Higher oil prices have stimulated oil production in Canada, magnifying the benefits from the improvement in the terms of trade. This is particularly true of Canada’s vast oil sands, where the higher prices have made them economically viable. To step up production requires more workers and more money. Where do they come from? What draws them in? The economy has natural market mechanisms that help. With the BIS central bankers’ speeches higher prices these sectors command on the world markets, profits, job markets and wages heat up, attracting more investors and more workers. As people earn more, they spend more and, as this work force grows, they need more of everything – from Tim Hortons to pickup trucks. This leads to more jobs and higher wages in other sectors and other regions of the economy, so everyone benefits. People move to where it’s hot As a share of GDP, investment in mining and oil and gas extraction has doubled since 2002. As companies step up their investments, they set off a chain of events that draws people in. Over the past ten years, about a quarter of a million people, net – roughly the population of Saskatoon – have moved from other provinces to Alberta. Last year alone, net migration to Alberta from the rest of Canada totalled nearly 45,000. Saskatchewan, too, has had more people move in than out over the past year. Between 2006 and 2011, about one in every five Saskatchewanians was either a newcomer or had moved a long distance within the province. For all of Canada’s workers, this is a sea change. While Alberta and Saskatchewan may be net recipients of people, there is still significant gross movement of people into and out of the “cooler” provinces and sectors. The fact is, lots of jobs are being created all over the country, demonstrating the economy’s ability to respond to changing circumstances. People are crossing the country not just for the jobs, but also for better wages. No matter how you cut the data, they consistently show that workers in Alberta, Saskatchewan, and Newfoundland and Labrador have seen their wages go up faster than anywhere else in Canada in recent years. Interestingly, in part because of this movement of people, gaps in the unemployment rates among the provinces have not widened in response to the terms-of-trade shock; rather, they have actually become smaller than they once were. The growth in job opportunities in hot areas is almost matched by a net migration of workers out of provinces where opportunities are less plentiful. Canada’s labour force is demonstrating remarkable flexibility, as workers from across the country move to find good jobs and good pay. However, this is not to say it’s easy. In places where it’s hot, they are scrambling to keep up with the demand for housing. Here in Saskatchewan and next door in Alberta, many more houses proportionately are going up than elsewhere in Canada. Further, the cost of maintaining a home in these provinces has increased by far more than anywhere else. For people outside the hot spots, it is a really big decision to move across the country. The people moving to the hot economies are leaving other areas – of both the country and the economy – and they are taking income and potential with them. This upheaval can be difficult for the regions and sectors that are losing workers. For families, the long-distance relationships it creates can be tough. In the long run, however, we are all better off with a positive terms-of-trade shock. While different regions and sectors adjust differently, and while these adjustments can be painful, they allow us to maximize the benefits of our rich energy endowment – and ultimately everyone gets the gift. Overall, Canada’s gross domestic income (GDI), a measure of the purchasing power of all income generated by domestic production, is approximately 7 per cent higher than it would have been without the improvement in the terms of trade since 2002. Yes, when we break this down by region, big benefits are accruing to the three oil-producing provinces. But those who suspect GDI is falling elsewhere will have to think again. Rather, everywhere in Canada, GDI is higher than it would have been without the improvement in our terms of trade. BIS central bankers’ speeches Where the terms of trade go, the loonie follows For Canada as a whole, where the terms of trade go, the loonie follows. International investors buy good-news stories and, when they buy Canada’s, the value of the Canadian dollar goes up. As a consequence, our terms of trade and the dollar move together, although not necessarily always in sync. It’s like walking a dog on one of those leashes that stretch out and snap back. You might hope he’ll stick by your side, but in reality the dog is always off in all directions. By the end, your respective tracks zigzag all over the place, much like an economist’s chart. But when you leave the park, you’re still together. That’s how the relationship between the terms of trade and the dollar looks: it’s loose, but dependable. It is also how the gift of a positive terms-of-trade shock gets spread even further. A stronger dollar gives the whole country greater purchasing power on global markets by bringing down the Canadian-dollar prices of imported goods and services. That means cheaper televisions, cheaper trips, cheaper tools. That’s good for Canadian consumers and for companies that buy machinery and equipment. Yes, it is true that, for some businesses, the stronger dollar also reduces their ability to compete in world markets – I’ll speak more about that in a moment. It is important to note that the terms of trade are not the only thing that affects the exchange rate. Other forces, of course, are important, in particular the U.S. dollar. In the post-crisis period, the U.S. dollar tended to be weaker against many other currencies, including ours. But in recent months, with the U.S. economy regaining its momentum, the loonie’s strength has diminished, coming down from its post-crisis peak. What’s not hot? Non-energy exports So far, I have been focusing mainly on the hot side of Canada’s economy. But let’s look at where growth is cooler – in the manufacturing sector. Here, the story is not so cut and dried. As I mentioned, the strengthening Canadian dollar in response to an improvement in the terms of trade contributes to the competitiveness headwinds faced by non-energy exporting companies, especially manufacturers. Added to this was the pain inflicted on manufacturers across advanced economies by the Great Recession that followed the financial crisis. Here in Canada, the crisis lowered the temperatures of both the energy and manufacturing tracks of our economy. But due in part to the magnitude of the hit felt south of our border and to the severe impact felt by the U.S. sectors important to Canadian manufacturers – including its residential housing sector and auto production – the crisis was particularly hard on our manufacturing exporters. Many manufacturers and manufacturing jobs simply disappeared. For the sector as a whole, the recovery has been a long time coming. Together, the two shocks – the terms-of-trade shock and the crisis – have walloped Canada’s manufacturers. Now, the world recovery is beginning to get under way, which will relieve the pressure of the shock of the crisis. However, the forces related to the changing terms of trade will continue to be felt, even as the global recovery proceeds. One shock is going away, but the other continues. Competitiveness challenges have prompted many Canadian manufacturers to become more productive. Some have streamlined their activities, introduced new products and services, entered new markets, and invested in cost-saving technologies. Others have outsourced product fabrication, but invested in product development and sales and service for new markets. We have seen gains in productivity among those manufacturing subsectors in which Canada has natural advantages, including primary metals, wood products, paper, and food. Since 2002, the greatest increases in manufacturing output per worker have occurred in these industries. BIS central bankers’ speeches We all know Canada’s is an export-driven economy. Growth since the crisis has been fuelled by policy, not natural forces. We need our economy to shift gears and for exports to lead again. The importance of manufacturing to the economy and, in particular, manufacturing exporters – and the growing wedge between our export performance and foreign demand – led the Bank to dig a little deeper to better understand the dynamics of what’s happening. To do that, we broke down the non-energy export sector into 31 subsectors and investigated at this more detailed level. We are discovering that, for many of these subsectors, exports have been behaving broadly in line with the fundamentals of foreign activity – or even better. For them, business is heating up. Subsectors that are expected to thrive as U.S. investment picks up include machinery and equipment, building materials, commercial services, and aircraft and aircraft parts. Other strong subsectors that are poised to heat up include pharmaceuticals, plastics, metal products, and travel and tourism. Some of these subsectors are expected to benefit from both the recent decline in the Canadian dollar and the stronger U.S. activity. Taken together, these subsectors constitute about half of Canada’s exports. So we are hopeful that, as their temperatures rise, these industries will help drive the recovery in Canada’s exports. Other subsectors, however, are still coping with competitiveness challenges, which have been developing for a long time and weigh on their ability to benefit from stronger growth abroad. These include auto and truck makers, food and beverage suppliers, and chemicals. Because their issues are longer-term, the recovery for these groups will be slower, even as they could be helped by the recent decline in the strength of the Canadian dollar. The Bank’s analysis has given us a more granular interpretation of the export picture – and gives us more hope for the recovery of our non-energy export sector. However, it also implies that the wedge we’ve observed between exports and foreign demand persists to some degree. While there is more restructuring of the Canadian economy in store, we expect a gradual convergence between the growth rate of Canada’s exports and that of foreign demand. The Bank is looking to industries that are out in front in terms of their knowledge, technical expertise or production advantages to lead the growth in Canada’s non-energy exports; for example, some of those companies supported by Innovation Place here in Saskatoon. We are looking to industries that have posted solid performance over the past decade and, frankly, industries of the future that we may not even be able to currently identify. Chances are, big bursts of growth will come from brand-new companies with brand-new products and services. But this process will take time; we need to be patient. In order to achieve a sustainably stronger profile of export growth, we cannot rely solely on the U.S. market. There is no doubt that an improving U.S. economy is good for Canada. However, the growth potential of emerging-market economies is projected to be about four times that of the world’s advanced economies. Ultimately, in addition to capitalizing on the stronger growth of these markets, diversifying our export markets will help reduce the risks associated with weakness in one export market. We can do this now, but as our various freetrade agreements fall into place, we will be able to do so even more effectively. Overall, we remain hopeful that rising global demand for Canadian goods and services, combined with the continued high level of oil prices, will stimulate business investment in Canada and shift the economy onto a more sustainable growth track. Consistent with this view, manufacturers interviewed by the Bank for our spring Business Outlook Survey indicated that, in an effort to improve competitiveness or to create opportunities for growth, they are planning to increase their investments in machinery and equipment. Such intentions are somewhat more prominent among small and medium-sized firms and among export-oriented firms. Statistics Canada’s recent survey of private and BIS central bankers’ speeches public investment intentions also shows that manufacturers across a broad range of subsectors are planning to increase investment. I’m encouraged by these intentions. With Canada’s stronger terms of trade, with our healthy business environment, with our ability to innovate, the future of Canada’s manufacturing sector is bright. Just as your favourite maple tree looks different every spring, the sector will evolve, at least on the surface. For instance, we can expect some parts of the manufacturing process to move offshore to lower-cost venues. In this respect, manufacturing is not just fabrication. Of course, it involves much more. Prior to fabrication, there’s research and development and design. Pre- and post-fabrication activities are high value-added services that reward skilled workers with high wages. At the same time, our rich resource endowment makes Canada a natural place for manufacturers of food, fabricated and primary metals, and forestry products. Hot or not: Where does monetary policy fit in? How does monetary policy fit into this? In effect, we make sure the big picture is balanced and we let these forces work themselves out beneath the surface. Our contribution is to keep inflation on track. However, even though monetary policy does not address sectoral or regional issues and, instead, is designed for the economy as a whole, the analysis I’ve described here feeds critically into our policy decision making. Our forecast is that, as a result of higher consumer energy prices, total inflation will rise in the next few quarters. These increases will have, by definition, transitory effects on trend inflation and in a year from now, they will come out of the numbers. In the meantime, what is crucial to the underlying inflation story is that we start from a low inflation rate. And that’s why we say that the downside risks to inflation remain important – because they would have the potential to push inflation significantly further away from our 2 per cent target. If we ask ourselves where those risks might come from, obviously, our story hinges critically on the outlook for our exports. We already have what looks like a soft landing emerging in housing, so it is crucial that at the same time there is a pickup of momentum in our exports, which we believe will then be followed by a pickup in business investment. Those two shifts will put our economy on a sustainable growth track. However, if, for some reason, the export recovery were less than we’re predicting, then total inflation, having gone up to target, will simply drift back down to converge with core inflation at perhaps around 1 per cent, because the output gap will be just as big as before. Either way, it should be clear that we are still a long way from home, as it will take until early 2016 to get underlying inflation back up to 2 per cent. Our economy has room to grow. And, when we do get home, there is a growing consensus that interest rates will still be lower than we were accustomed to in the past – both because of our shifting demographics and because, after such a long period at such unusually low levels, interest rates won’t need to move as much to have the same impact on the economy. Last week, reflecting our analysis, we maintained the target for the overnight rate at 1 per cent. Conclusion It’s time to wrap up. We can’t be 100 per cent sure that oil prices will stay high indefinitely. We have a forecast, but the circumstances can obviously change. What’s crucial is that the Canadian economy maintain its ability to adapt to shifting temperatures. Diversifying our export markets is important to future growth and resilience. Just as when you travel from one part of Canada to another, the weather can be dramatically different – hot in the Okanagan, bone-chilling cold in the Prairies and moderate in the Maritimes – local economies can cover the gamut from hot to not. We are fortunate that we BIS central bankers’ speeches can see these shifts in economic temperatures as they occur. The key is having an economy that is flexible enough to sustain the shocks and adjust to them smoothly. The more we know about the shocks and adjustments, the better prepared we are and the better able we are to benefit from everything this great country of ours has to offer. BIS central bankers’ speeches
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Speech by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Senate Standing Committee on Banking, Trade and Commerce, Ottawa, 30 April 2014.
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Stephen S Poloz: Opening statement before the Senate Standing Committee on Banking, Trade and Commerce Speech by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Senate Standing Committee on Banking, Trade and Commerce, Ottawa, 30 April 2014. * * * Thank you for the opportunity for Tiff and me to be here today to share with you highlights from the Bank of Canada’s recent economic outlook. The Bank aims to communicate openly and effectively so that Canadians know how we are achieving our mandate to promote the economic and financial welfare of this country. One of the best ways we do this is by appearing before this committee and answering your questions. I will discuss the Bank’s outlook for inflation, then move on to our outlook for global and Canadian economic growth; I will touch on some recent Bank research and finish with trends that we are observing. Inflation Inflation in Canada remains low. We expect core inflation to stay well below our 2 per cent target this year, returning to target over the next two years. Total CPI inflation, however, will move closer to the target in the coming quarters, due to temporary factors. Allow me to explain. We expect economic slack and heightened retail competition to keep core inflation below target until early 2016, while higher consumer energy prices and a lower Canadian dollar will contribute to total CPI inflation moving up. Total CPI inflation will remain fairly close to target throughout our projection period, even as upward pressure from energy prices dissipates, because the impact of retail competition will gradually fade and excess capacity will be absorbed. When this happens, core inflation will gradually make its way up to 2 per cent and catch up with total CPI inflation from below. Economic outlook Moving to our economic outlook, global growth should gather steam in the coming three years as the headwinds that have dampened growth dissipate. Overall, we see global economic growth picking up to 3.3 per cent in 2014, moving to 3.7 per cent in 2015 and 2016. In Canada, real GDP growth is expected to average about 2 ½ per cent in 2014 and 2015 before easing to around 2 per cent. These numbers are essentially in line with the Bank’s January outlook, but they don’t reflect the actual quality of the outlook, which has changed in meaningful ways, especially for emerging-market economies and Europe. Growth in Europe is modest, but inflation remains too low, and hopeful signs of recovery might be stalled by the Russia-Ukraine situation. China and other emerging economies are showing solid growth, although there are some growing concerns about financial vulnerabilities – specifically, increased market volatility in response to political uncertainty. BIS central bankers’ speeches The economic recovery in the United States, however, is proceeding as expected, despite recent softer results largely due to unusual weather. In fact, private demand could turn out to be stronger than we had thought. The issues Canada’s economy faces are not unfamiliar to you. Competitiveness challenges continue to weigh down our export sector’s ability to benefit from stronger growth abroad. Given the importance of the export sector to an open economy such as ours, and given the growing wedge between Canada’s exports and foreign demand, the Bank has deepened its analysis of the export sector, specifically, non-energy exports. Non-energy exports By breaking down the non-energy export sector into a large number of subsectors, interesting facts and trends emerge. To start, we are discovering that there are subsectors, such as machinery and equipment, building materials, commercial services, and aircraft and aircraft parts, that are in line with fundamentals, or even doing better than their respective U.S. benchmarks. This suggests that, as the U.S. recovery gathers momentum and becomes more broadly based, many of our exports will benefit. The lower Canadian dollar will also contribute to the recovery of these subsectors. Other subsectors, including auto and truck makers, food and beverage suppliers, and chemicals, will also be helped by a lower dollar, but to a lesser extent, since they are experiencing greater competitiveness challenges. Their recovery will be slower. The big picture tells us to expect a gradual convergence between the growth rate of Canada’s exports and that of the U.S. economy. But this more granular research indicates that the wedge between exports and foreign demand will endure. And make no mistake. This wedge is real and it is big. The good news is that we now know more precisely just where it is – with about half of our non-energy exports. The bad news is that these subsectors are doing worse individually than we thought before. This deeper understanding of our export sector is valuable, but it does not make us any less concerned about the challenges ahead. Looking forward, we continue to believe that rising global demand for Canadian goods and services, along with the assumed high level of oil prices, will stimulate business investment in Canada and help shift the economy to a more sustainable growth track. Trends We continue to expect a soft landing for the housing market and Canada’s household debtto-income ratio to stabilize. Nevertheless, the imbalances in the housing sector remain elevated and would pose a significant risk should economic conditions deteriorate. We are observing, anecdotally at least, an increased awareness of this risk. Consumers are showing responsibility; for example, homebuyers who opt to buy less house than they qualify for so they don’t find themselves overextended if interest rates rise. Banks, as well, are underwriting loans more carefully, ensuring that people can service their debts if rates go up. So, while the risk could be significant, we are comfortable that it is not outsized. To sum up, the Bank continues to see a gradual strengthening in the fundamental drivers of growth and inflation in Canada. But this view depends largely on the projected upturn in exports and investment. There is a growing consensus that when we do get home, interest rates will still be lower than we were accustomed to in the past – both because of our shifting demographics and BIS central bankers’ speeches because, after such a long period at such unusually low levels, interest rates won’t need to move as much to have the same impact on the economy. With underlying inflation expected to remain below target for some time, the downside risks to inflation are important, as are the risks associated with household imbalances. The Bank judges that the balance of these risks remains within the zone for which the current stance of monetary policy is appropriate and, as you know, we decided on 16 April to maintain the target for the overnight rate at 1 per cent. The timing and direction of the next change to the policy rate will depend on how new information influences the balance of risks. Conclusion Before Tiff and I respond to your questions, I would like to take just a moment to say a few words about the man sitting next to me. Tiff’s contributions at the Bank started long ago as a new recruit with a fresh master’s degree in hand. His contributions throughout his career have been significant. At the Bank, we will miss him for his intellect and management skills. But we will also miss a great friend to many, myself included. We can rest assured that Tiff’s contributions to the financial welfare of Canada will continue as the Dean of the Rotman School of Business, where he will be busy ensuring that the next generation of economists and business leaders are prepared to take Canada into a prosperous future. Tiff did such a great job as Senior Deputy Governor that, to find his replacement, we have had to split the position and look for two people to fill his shoes. I am pleased to report that we will be in safe hands. And, I look forward to introducing you to Carolyn Wilkins, the incoming Senior Deputy Governor, who will oversee the Bank’s strategic planning and operations and will share responsibility for the conduct of monetary policy. I also look forward to working with our new Chief Operating Officer, Filipe Dinis, who will be responsible for managing all of the Bank’s administrative functions. And with that, Tiff and I are happy to take your questions BIS central bankers’ speeches
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Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, to the Pension Investment Association of Canada, Quebec City, Quebec, 15 May 2014.
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Lawrence Schembri: Double coincidence of needs – pension funds and financial stability Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, to the Pension Investment Association of Canada, Quebec City, Quebec, 15 May 2014. * * * Introduction Thank you for the invitation to address your spring conference. One of my responsibilities at the Bank of Canada is overseeing our analysis of the financial system in Canada and globally, and our activities to support its stability and efficiency. The Bank’s core mandate is to promote the economic and financial welfare of Canada, so we take a system-wide view of how the different components of the financial system fit together to form a stable and efficient whole. The Bank is not responsible for prudentially regulating and supervising the activities of individual financial institutions.1 Rather, our perspective is the entire financial system. Its stability is an important precondition for effectively implementing monetary policy, and for achieving low and stable inflation and promoting sustainable economic growth. We bring that system-wide perspective to the table when contributing to the development of global financial reforms and their implementation in Canada, in collaboration with federal and provincial regulatory agencies. In Canada, the financial system is large and well developed; its assets amount to about 500 per cent of GDP. The pension industry holds about 13 per cent or roughly $1.2 trillion of those assets, and is second in importance only to the banking system.2 Of the almost 8,000 pension funds in Canada, four are included in a list of the world’s 40 largest pension funds.3 Because the pension fund sector has such a significant presence in the Canadian financial system, we, at the Bank of Canada, are interested in better understanding it. For this purpose, I am here to talk to you today about the role that we see the pension industry playing in the financial system, and, in particular, its contribution to financial stability. We strongly believe that healthy, well-managed pension funds help to reduce systemic risk and preserve financial stability. And a stable financial system helps maintain the health of pension funds. We want to work with you to strengthen the contribution you make to financial stability, so your feedback is important. I’ll first discuss this double coincidence of needs – your need for financial system stability and the system’s need for robust, well-managed pension funds. Second, I’ll review the challenges faced by pension funds in this low-for-long, post-crisis environment, which is the timely and important theme of this conference. Under the Payment Clearing and Settlement Act, the Bank of Canada has responsibility for the prudential oversight of systemically important financial market infrastructures. International Monetary Fund, “Canada: Financial Sector Stability Assessment”, Country Report No. 14/29, February 2014. The four pension funds are: CPPI Investment Board, Ontario Teachers’ Pension Plan, PSP Investments, and OMERS (The Economist, 3 March 2012). www.economist.com/node/21548970. BIS central bankers’ speeches Third, I will examine how the G-20-sponsored global financial reforms will improve stability by strengthening the resilience of the global financial system. And I’ll comment on the implications of these reforms for pension funds. Just to be clear, the reforms are not targeted at pension funds, which were a source of resilience during the crisis. Rather, they address the serious fault lines exposed by the crisis. All financial sectors, including pension funds, stand to benefit from the reforms, which will reduce the likelihood and adverse impact of future crises. Financial stability: its importance to pension funds Why is financial stability important for pension funds? To answer this question, let’s start by defining what we mean by financial stability in this context. It is important to recognize that volatility does not necessarily imply financial instability. Asset prices in well-functioning markets typically exhibit some degree of volatility because they reflect the arrival of new information and a diversity of opinion. Generally, such diversity and volatility are positive because they are consistent with liquid and efficient markets. But there are instances – in 2008, for example – when volatility spiked because market liquidity had dried up. In such circumstances, the financial system cannot perform its critical intermediation function, resulting in adverse effects on real economic activity. Hence, the Bank defines financial stability as the resilience of the financial system to unanticipated adverse shocks to enable the continued functioning of the financial intermediation process.4 Given this intuitive definition of financial stability, it is clear that financial system instability can undermine the fundamental objectives of pension funds. Without financial stability, it would be difficult for sponsors to develop and confidently fulfill a pension promise. Pricing in a well-functioning market is critical to assessing and managing risk with confidence. To understand why, let me give you a macroeconomic perspective of the recent financial crisis. The financial crisis had pervasive adverse financial and economic impacts. Financial markets and institutions came under severe stress and economic activity slowed sharply as the Great Recession took hold. Pension funds experienced large losses as asset prices plunged. Central banks responded by aggressively reducing interest rates and providing extraordinary liquidity in an effort to restore financial market functioning and support economic activity. In the absence of central bank and other public policy actions, the immediate impact of the crisis on pension funds would have been far worse. Indeed, a repeat of the Great Depression was avoided. However, given the slow recovery of the global economy, central banks have kept their policy rates low for an extraordinarily long period and have resorted to unconventional means to provide additional stimulus. While these measures have raised asset prices, low interest rates pose a serious challenge for pension funds.5 Bank of Canada, Financial System Review, (December 2013): iii. The Mercer Pension Health Index in Canada, which tracks the ratio of assets to liabilities for a model defined benefit pension plan, shows that the ratio fell to slightly more than 70 per cent in early 2009 and began rising in 2010 but fell below 80 per cent again in 2012. It has since recovered and at the end of March it stood at 104 per cent. These movements reflect the immediate decline in asset prices and their subsequent recovery, but also the impact of the low interest rate environment on the discount rate. The combination of the immediate decrease in asset values and the increase in liabilities led to a large unfavourable swing in the BIS central bankers’ speeches The Bank of Canada monitored pension funds during the crisis and took actions to support market liquidity because we recognized that it was critical for them and for other market participants.6 Let’s now look at how pension funds can best contribute to financial stability. Pension funds: their contribution to financial stability The simple answer is that, given their size and importance to the Canadian and global financial systems, pension funds contribute meaningfully to financial stability by helping to maintain the diversity of market behaviour. Diversity across financial market participants underpins well-functioning markets and a resilient financial system by reducing common exposures and procyclicality. Pension funds contribute importantly to financial diversity because they are among the most varied and thus the most “cool” market players for three main reasons: • First, pension funds are market participants with long investment horizons. • Second, they are predominantly real-money investors; that is, they fund their investments primarily from contributions, rather than from borrowing. • Third, employee and employer contributions are largely locked in. Allow me a few comments on each of these sources of diversity. Because pension funds are investing to help fund the retirements of members over a wide age distribution, they have the luxury of patience, of being able to withstand short-term market volatility or liquidity stresses to earn returns over the long term. They are the Warren Buffetts of the financial system. In other words, pension funds can more easily bear market and liquidity risk and earn the associated risk premiums because they can diversify these risks over time.7 Their long investment horizons are different from those of most other market participants, who are more focused on short-term returns. Thus pension funds have the capacity to smooth and absorb short-term volatility and act as a net provider of liquidity and collateral to the system, especially in times of stress. Pension fund rules for asset allocation, position limits and rebalancing work in the direction of smoothing asset prices. Rebalancing encourages pension funds to sell assets that have gained in relative value and vice versa. Consequently, via rebalancing, pension funds can help to mitigate excessive asset price movements. Pension funds do not rely primarily on borrowing to fund their investments, and are not vulnerable to excessive leverage or significant liquidity and maturity mismatches, which funding status of pension funds, greatly increasing the burden on plan sponsors in the aftermath of the financial crisis. The Mercer Pension Health Index assumes contributions equal to the current service cost plus solvency deficit payments, and no plan improvements http://m.mercer.ca/press-releases/1593805?detail=D. Note that, in contrast, the risk for defined contribution plans was borne by the beneficiaries, although the impact was equally serious. For example, in February 2009 the Bank of Canada included private sector bonds in the list of acceptable collateral for term purchase and resale agreements. Credit risk generally increases over time. For more information, see J. Nugée and A. D. Persaud, “Redesigning Regulation of Pensions and Other Financial Products”, Oxford Review of Economic Policy, 22, no. 1 (Spring, 2006): 66–77. BIS central bankers’ speeches caused many banks, both traditional and shadow banks, to fail during the crisis.8 Hence, they are, in general, not a source of systemic risk to the financial system. Finally, because the contributions to most pension funds are locked in, they are not subject to massive withdrawals or runs of the kind we witnessed during the financial crisis, such as Northern Rock or U.S. money market mutual funds. Given these important differences from other market participants, pension funds have had, in general, a positive impact on financial stability. Although not definitive, there is some anecdotal evidence that pension funds contributed to financial stability during the crisis by acting in a countercyclical fashion, buying assets when their prices fell.9 Recent challenges and responses In recent years, however, pension funds have encountered three major challenges that have affected their ability to play this stabilizing role. By far the biggest challenge faced by defined-benefits pension funds since the financial crisis has been the low level of long-term interest rates. Low rates have increased the value of their liabilities and sharply reduced their solvency ratios, especially in the immediate aftermath of the crisis. These ratios have now partially recovered, as low interest rates have boosted equity prices, but interest rates are likely to remain relatively low for an extended period as the Canadian and global economies slowly recover.10 In their search for yield in this low interest rate environment, many pension funds have increased their exposure to alternative investments in real estate, private equity and infrastructure. Given their long investment horizons, they are well suited to holding a portion of their funds in less-liquid assets to earn a liquidity premium. As long as the liquidity, market and credit risks associated with these investments are prudently managed, this is a positive development.11 A second challenge is longevity. According to the Canadian Institute of Actuaries, existing mortality tables based on the U.S. experience significantly understate Canadian life expectancy by 2.3 years for a 65-year-old man and by 3.3 years for a woman of the same age. As funds transition to the new Canadian mortality tables, pension obligations could rise by as much as 7 per cent, although the typical increase will likely be in the range of 3 to 4 per cent.12 Clearly, a challenge of this magnitude, especially one that will likely persist or even increase, may not be fully addressed by asset-management strategies alone. In some cases, adjustments to contribution rates and benefit levels will be part of the solution.13 Pension funds that invest directly in real estate or infrastructure, for example, sometimes borrow against this collateral to help to finance their purchases or they may invest indirectly in related funds, whose managers may also borrow. For mixed evidence of the countercyclical behaviour of U.K. pension funds during the crisis, see A. Haldane, “The Age of Asset Management?” (Speech delivered at the London Business School, London, U.K., 4 April 2014). www.bankofengland.co.uk/publications/Documents/speeches/2014/speech723.pdf. Recent increases in long-term interest rates have also improved solvency ratios. Also see K. Ambachtsheer et al., “Risks of a Prolonged Low-Interest-Rate Environment for the Pension Sector”. Report Submitted to the Global Risk Institute, Rotman School of Management, University of Toronto. (September 2013). In their search for yield, pension funds should avoid taking in “crowded” positions and taking other common exposures that reduce market diversity and their contribution to financial stability. Canadian Pensioners’ Mortality, Canadian Institute of Actuaries, Final Report, February 2014. www.ciaica.ca/docs/default-source/2014/214013e.pdf?sfvrsn=4. Outside of Canada, some pension plans have transferred longevity risk to insurance companies, for example. BIS central bankers’ speeches A third challenge has been the introduction of fair-value accounting for pension promises and the interaction with regulatory solvency requirements. The new accounting rules, which use the yield of AA corporate bonds to discount liabilities while valuing assets at current market prices, have led to an increase in balance sheet volatility. In response, many funds have attempted to “de-risk” their plans with higher allocations to long-term bonds, which provide a better hedge against the impact of interest rate fluctuations on their liabilities. However, to compensate for the opportunity cost of a smaller equity weight, some funds have also leveraged their bond portfolios. While the use of leverage may help to raise returns, it also increases risk, because such a position may be difficult to roll over in stressed markets.14 The pressure to minimize the volatility created by fair-value accounting and solvency rules may also entice some funds to favour strategies that shorten their investment horizons.15 However, such “short-termism” may be costly, since it could detract from the contribution that pension funds can make to financial stability. Fortunately, most funds are committed to disciplined rebalancing, which will allow them to play a stabilizing role in our financial system. In addition to these challenges, pension funds will also have to adjust to major reforms to the global financial system that are currently under way. Let me give you a brief overview of those reforms. Financial reform and pension funds In the wake of the financial crisis, G-20 Leaders adopted a sweeping set of financial sector reforms to build a stable and resilient global financial system that will promote global economic integration and sustainable growth.16 At the macro level, the reforms will make the global financial system more resilient to shocks. Financial crises will be less frequent and less severe, which will clearly benefit pension funds as well as other market participants. At the micro level, pension funds will be affected by the implementation of four priority reforms: • the enhanced Basel III bank capital and liquidity framework; • an effective resolution regime for financial institutions that are seen as “too big to fail”; • requirements to reduce systemic risk in shadow banking; and • rules and infrastructures for over-the-counter derivatives. Basel III Since pension funds are low credit risk exposures for banks, the impact of the new Basel III capital rules on pension funds will be small. Under the new liquidity rules, however, pension Bank of Canada, Financial System Review, (December 2012): 36–38. For example, long-short equity strategies. For more information, see C. Severinson and J. Yermo, “The Effect of Solvency Regulations and Accounting Standards on Long-Term Investing: Implications for Insurers and Pension Funds”, OECD Working Papers on Finance, Insurance and Private Pensions, No. 30, OECD Publishing (November 2012). http://dx.doi.org/10.1787/5k8xd1nm3d9n-en. The G-20’s four core reform priorities are: (1) to make banks safer; (2) to end the problem of financial institutions that are “too big to fail”; (3) to transform shadow banking activities into resilient market-based finance; and (4) to ensure continuously functioning core financial markets. For an update on the reforms, see www.financialstabilityboard.org/publications/r_140411.pdf. BIS central bankers’ speeches funds may have to increase the amount and quality of the collateral supplied to banks for derivatives, repo and securities-lending transactions. Resolution A key component of the framework to achieve the resolution of large financial institutions without disrupting the financial system will be new “bail-in” debt and preferred-share instruments, which can be converted to common equity to absorb losses should the institution come under stress.17 These instruments will be issued in large amounts and will have equity-like characteristics that pension funds may find attractive. Shadow banking The shadow banking reforms can be viewed through two lenses: (i) financial market activities, particularly, repos, securities lending and securitization; and (ii) less regulated financial institutions, such as money market funds, finance companies, hedge funds and managed-asset funds. Because the sector is so heterogeneous, broad regulatory principles, rather than explicit reforms, have been developed that jurisdictions can apply to mitigate systemic risk – namely, to reduce procyclical behaviour and the likelihood of runs. These principles focus on reducing four sources of systemic risk: excess leverage; undue liquidity and maturity transformation; imperfect credit risk transfer due to incentive problems; and a lack of transparency. It is important to stress that pension funds, while a type of managed asset fund, are not normally considered to be a source of systemic risk, despite providing non-bank financial intermediation, because these four sources of systemic risk are generally not present. Nonetheless, pension funds will be affected by these shadow banking requirements to the extent that they engage in these activities or interact with these institutions. In particular, certain repo and securities-lending transactions will be subject to minimum haircuts to reduce procyclicality. Central counterparties for repos and over-the-counter derivatives For repo and derivatives transactions, central counterparties reduce common counterparty exposures and systemic risk. We are encouraging some of the largest and most active pension funds in the Canadian repo market to become direct clearing members of the Canadian Derivatives Clearing Service (CDCS), the central counterparty (CCP) owned by TMX Group. The goal is to allow the large pension funds to participate directly in CDCS in a way that permits risk to be managed without requiring them to be subject to mutualized losssharing arrangements. Less-active pension funds should become indirect clearers through a dealer to realize these benefits. Such participation will greatly enhance the resilience of the repo market. Similarly, pension funds should clear interest rate swaps through a bank that is a clearing member of SwapClear in London.18 Both of these CCPs come under the surveillance of the Bank of Canada. Financing long-term investment The G-20 is committed to creating a climate that facilitates increased long-term investment, particularly in infrastructure.19 To achieve that goal, the G-20 will promote private financing, The preferred-share instruments are known more formally as non-viable contingent capital. See remarks by Assistant Superintendent Mark Zelmer to the BMO “First Annual Reserve Management Conference”, Toronto, 7 May 2013. www.osfi-bsif.gc.ca/Eng/Docs/mz20130507.pdf. Because the use of CCPs reduces counterparty risk, collateral requirements will be less than those for bilaterally cleared transactions, not only for the parties involved, but also for the system as a whole. BIS central bankers’ speeches potentially through pension funds and possibly with the use of high-quality securitization instruments. This is a positive development for Canadian pension funds because they are already active in funding infrastructure globally.20 Conclusion I’d like to conclude by emphasizing again that we recognize the contribution that pension funds make to financial stability. We want to work with you to enhance this contribution because what makes you stronger makes the system stronger. For our part, as public authorities we need to ensure that the reforms are coherent and don’t conflict with existing regulations, particularly tax and solvency rules. We also need to coordinate regulations and information sharing across federal and provincial agencies. In this regard, the Canadian Association of Pension Fund Regulators has made important and useful contributions, but more can be done. And we need to encourage the safe use of derivatives and other instruments, such as a repo CCP, to better manage risk. For your part, your funds must have realistic return targets and effective risk governance. Our combined efforts will help to promote a stable and more resilient financial system that will better serve not only your plan sponsors and beneficiaries, but all Canadians. Thank you. Communiqué, Meeting of Finance Ministers and Central Bank Governors, Sydney, 22–23 February 2014. Canadian-based public pension funds have an average current allocation in infrastructure investments of 5.9 per cent and a target allocation of 8 per cent. See “Comparing Infrastructure Investments among U.S. and Canadian Public Pensions – February 2014”, Preqin. https://www.preqin.com/blog/101/8338/us-canadapublic-pensions. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Financial System Review, Ottawa, Ontario, 12 June 2014.
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Stephen S Poloz: Release of the Financial System Review Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Financial System Review, Ottawa, Ontario, 12 June 2014. * * * Good morning. It is my pleasure to hold this press conference with Carolyn Wilkins. Carolyn assumed the post of Senior Deputy Governor of the Bank of Canada on the 2nd of May. We are pleased to be here with you today for the inaugural press conference for the Financial System Review (FSR). The Bank published the June issue this morning. An important part of the Bank’s work is to promote a stable and efficient financial system. We do this in a number of ways: providing liquidity facilities and serving as lender of last resort; overseeing key domestic clearing and settlement systems; and collaborating with domestic and international policy-makers to develop and implement policy. Our research and analysis of financial stability is vital to this work. Since 2002, the FSR has been our flagship publication for promoting informed public discussion on all aspects of the financial system. This morning’s press conference extends that effort. Our job today is to help you leave with a solid understanding of the Bank’s assessment of financial stability in Canada, an appreciation of the complexity of the analysis and, importantly, how this work fits into our thinking about Bank policy. Let me provide some context. Over the two decades leading up to the global financial crisis, a consensus emerged that keeping inflation low, stable and predictable was the best contribution that monetary policy could make to the financial well-being of Canadians. Our inflation-targeting framework has always had a degree of flexibility built into it; and financial stability issues have always been part of the discussion. However, the crisis crystallized the view that financial stability and the outlook for economic growth and inflation are intrinsically linked. As a result, the Bank of Canada – like many other central banks – is reconsidering how to better integrate financial stability and monetary policy objectives. The assessment of financial stability is becoming more rigorous and now follows a more structured analytical process, informed by models, better data and richer dialogue. This leads to more informed judgments around the risks to the financial system. In this issue of the FSR, we have introduced an enhanced framework that explicitly identifies the underlying vulnerabilities in Canada. These are the pre-existing conditions that could amplify and propagate shocks through the Canadian system, regardless of where they originate. This sets the stage for assessing risks – events that, if they occurred, would threaten the ability of the financial system to perform its core functions. Such risks materialize when trigger events interact with vulnerabilities to cause stress in our financial system. This added depth allows a more complete understanding of our financial stability concerns. One can see that these diverse risks cannot literally be summed to estimate an overall level of risk. Nevertheless, after weighing the risks to financial stability through our improved framework and applying judgment, our level of comfort as policy-makers remains similar to what it was six months ago. The clear separation of cause and effect – vulnerabilities and risks – allows a more accurate weighing of the risks to economic and financial stability. It allows us to consider both in an integrated fashion as we deliberate policy. That’s why our assessment of the risks to the financial system is so relevant. And that’s why we’re here with you now. Before Carolyn and I take your questions, let me note the highlights from today’s FSR. BIS central bankers’ speeches The top two vulnerabilities are related to the household sector. The first is the imbalances in Canada’s housing market. We still anticipate a soft landing. However, stretched valuations and some signs of overbuilding would expose the financial system to a sharp correction in house prices – which is a risk we’ve identified. The second is the elevated level of indebtedness among Canadian households. This leaves households vulnerable to an unemployment shock or a sharp rise in interest rates. The third vulnerability is our exposure to sizable potential external shocks. An example is the significance of global commodity prices to our economy and financial system. The risks are viewed in the context of these vulnerabilities. The most important domestic risk is, as mentioned, a sharp correction in house prices. The probability of this risk materializing is low, given the expected strengthening of the global and Canadian economic recoveries. However, if it were to happen, its impact on the economy and financial system would be severe. We also focus on three other key risks: a sharp increase in global long-term interest rates; stress emanating from China and other emerging markets; and serious financial stress from the euro area. Before I open the floor to you, it is important to note that Canada’s financial system remains robust. It will continue to benefit from enhanced policy measures as the G-20 reform agenda is implemented, both domestically and globally. With that, Carolyn and I are happy to take your questions. BIS central bankers’ speeches
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Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, to the Canadian Payments Association, Charlottetown, Prince Edward Island, 27 June 2014.
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Lawrence Schembri: Dual vision for the Canadian payments system Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, to the Canadian Payments Association, Charlottetown, Prince Edward Island, 27 June 2014. * * * Introduction Thank you. It is a privilege and pleasure to be here with you today at this important conference. As many of you know, the Bank of Canada has a strong interest in the evolution of our payments system that goes well beyond our role as purveyor of the simplest form of payment – cash. This interest stems not only from our oversight responsibility for systemically important payment systems under the Payment Clearing and Settlement Act, but also from the important role these systems play in the transmission of monetary policy. Indeed, working with you and other stakeholders to improve payments falls squarely within our mandate to promote the economic and financial welfare of Canada. Today, I want to share with you a dual vision for Canada’s payments system and its oversight. While I won’t claim that all of the elements of this vision are original, I hope that by articulating it, we can begin a much-needed dialogue on how to improve our payments system and move it into the 21st century. Canada’s payments system is undergoing rapid and fundamental change. The bulk of it is driven by the combined forces of technological innovation and the desire of consumers to realize the benefits, most notably the convenience, of new technologies. But is all of this rapid change going in the right direction? Is it sufficiently coordinated? Is it safe? Is it sound? Are users’ interests well protected? These are important questions. And addressing them represents the important challenges we all face. We must respond – in a coherent and far-sighted manner. Payment systems matter to Canadians. Every year, we make approximately 24 billion payments, worth more than $44 trillion. These payments not only affect our daily lives, but they also have a profound impact on the effectiveness of our financial system in promoting economic activity, both here in Canada and externally. To coordinate our response and ensure that we are progressing in the right direction, we need a dual vision for Canada’s payments system and its oversight, one that promotes efficiency-enhancing innovation while managing the risks associated with the adoption of new technologies. My address today will contain three important elements: First, a vision for our payments system – one that meets the evolving needs of consumers and businesses and thereby supports productivity growth and improving living standards. Second, a vision for the oversight of the payments system – one that helps to ensure its safety and soundness, its efficiency and its security. And third, a coordinated approach for achieving this dual vision – one that calls on the payments industry and regulatory agencies to work together to attain this collective goal. BIS central bankers’ speeches A vision for the payments system In considering a vision for the payments system, let’s take a holistic perspective.1 The oftenused distinction between retail payment systems, which involve many end-users and smaller transactions, and wholesale or interbank payment systems, may not be appropriate when considering a vision for the future. Instead, a more comprehensive view reflects a future in which technological change will allow retail and wholesale systems to offer similar services and thereby compete more directly for a share of the same payments pie. My vision for the payments system draws from work that has already been done in Canada and in other jurisdictions to map out a desirable path for the future evolution of payments. We are not alone in wanting to move toward an innovative, safe and secure payments system that evolves to meet the needs of consumers and businesses. This vision maintains the best characteristics of our legacy system, while allowing for the advantages that innovations promise. Such a payments system has six essential attributes:2 (i) high speed – end-to-end processing in near real time; (ii) low cost – efficient and convenient; (iii) open access and ubiquitous usage; (iv) improved cross-border functionality; (v) safe, sound and reliable; and (vi) secure – to protect the private information of users. I will consider the first four attributes now and leave the last two for the discussion of the vision for oversight.3 Comparing Canada’s existing payments system to this vision, it is clear there are many gaps.4 In particular, in this era of instant communication, Canadians expect to be able to send and receive payments faster, at any time, and at low cost, without having to know the recipients’ banking information. Some progress has been made, however. The wider use of digital payments technology has increased speed, lowered costs and broadened access to the payments market. For example, between 2008 and 2011, the number of credit and debit card payments rose by 23 per cent and 17 per cent respectively.5 An example of an all-encompassing definition of a payments system is: a set of “arrangements that allow consumers, businesses and other organizations to transfer value from one party to another. It includes the institutions, instruments and services that facilitate the transfer of value between parties in a transaction.” See Task Force for the Payments System Review, Going Digital: Transitioning to Digital Payments, Chapter 1 (n.d.): 8. These attributes are discussed in: Task Force for the Payments System Review, “The Way We Pay: Transforming the Canadian Payments System” (July 2011); Canadian Payments Association, “CPA Payments Strategy: Vision 2020” (February 2010); The Federal Reserve Banks, “Payment System Improvement – Public Consultation Paper” (September 2013); Reserve Bank of Australia, “Strategic Review of Innovation in the Payments System: Conclusions” (June 2012). The use of global payment message standards will help to ensure the necessary information content to facilitate achievement of the first four attributes. See, for example, Task Force for the Payments System Review, “The Way We Pay: Transforming the Canadian Payments System” (July 2011). Canadian Payments Association, “Examining Canadian Payment Methods and Trends” (October 2012). BIS central bankers’ speeches Electronic funds transfers continue to replace cheques for bill payments and payroll transactions.6 Although there are fewer users, electronic person-to-person and e-wallet transactions have grown at the impressive rate of about 40 per cent annually over the same period.7 And then there are the new kids on the block – digital currencies – which, while more limited in market penetration, have the potential to be game-changers by achieving low-cost, faster, end-toend payments. These innovations meet the important attributes of speed, convenience, lower costs and efficiency, but fall short when it comes to ubiquity. New payment systems will only realize their full potential when they attain the universal participation that legacy systems enjoy. Despite many advances, the expression “the cheque is in the mail” is still a reality for many Canadian businesses. The recent Task Force for the Payments System Review highlighted that our businesses are still among the most cheque-reliant of the major economies.8 What is needed is an electronic invoice and payment system to facilitate the end-to-end automated processing of business-to-business payments.9 We also need to improve significantly cross-border payments. An analysis by the Canadian Payments Association (CPA) revealed that international payment needs are not currently being met.10 Compared with domestic payments, cross-border payments involve higher transaction costs and longer processing times associated with converting from one national payment system to another. To achieve these four important characteristics, our core national payment clearing and settlement systems should be upgraded. The Automated Clearing Settlement System (ACSS) was implemented in the early 1980s, and is showing its age. Access is limited, settlement occurs the next day and end-to-end processing of payments is slow. The Large Value Transfer System (LVTS) was implemented in 1999. It, too, could benefit from technological enhancements to clear and settle both retail and wholesale payments more efficiently. A vision for oversight To complement this vision for the payments system, we also need a new, more comprehensive vision for its oversight. The arrival of new players in the retail payments market calls for a fundamental overhaul of the Canadian oversight framework. As new systems compete with existing core systems, important public policy issues emerge. The goal is to create a level playing field for all systems, taking into account that some pose more risk than others. We achieve this through a holistic oversight approach that encompasses three broad types of payment systems: (i) systemically important systems; (ii) prominent payment systems; and (iii) other national retail payment systems. Changes to back-office processes have also led to quicker access to funds. Canadian Payments Association, “Examining Canadian Payment Methods and Trends” (October 2012). Task Force for the Payments System Review, Going Digital: Transitioning to Digital Payments, (n.d.): 18. The processing of digital images of cheques is an improvement, but is not the best solution, given available technology. Canadian Payments Association, “CPA Payments Strategy Vision 2020” (February 2010): 8. BIS central bankers’ speeches Such an approach will reinforce the efforts of the payments industry to achieve three important public policy objectives:11 (i) safety and soundness; (ii) efficiency; and (iii) meeting users’ needs and protecting their interests.12 Like vital public utilities such as power and water, core national payment systems must be both safe and sound to ensure continuous operations. They must be designed and operated to ensure that risk is effectively managed, using international standards,13 and providing open risk-based access and ubiquitous coverage. Core systems need to be efficient to remain competitive by keeping costs low. These key attributes will help to ensure that the critical mass of participation required to realize economies of scale and maximize social benefits will be achieved. The Bank of Canada is working with the Department of Finance to develop a new comprehensive framework for the oversight of payment systems that articulates this vision. It needs to be flexible, forward looking, and risk-based to meet public policy objectives, even as payment systems evolve and new trends emerge. The challenge is to find the balance between ensuring safety and promoting efficiency. The oversight framework must instill confidence in the payments system and foster innovation and competition to meet user needs, support economic growth and promote financial stability. New players that are not currently subject to the same comprehensive regulatory oversight as traditional incumbents must be brought into the framework. In this vision, the Bank of Canada may play a larger role by overseeing prominent payment systems, in addition to those that are systemically important.14 Through this expanded role, within the new oversight framework, we would be able to help maintain a safe and efficient payment infrastructure, even as the market responds to emerging trends and end-user needs. What would this potential change in the Bank’s role mean for the CPA? Initial analysis indicates that the CPA’s ACSS exhibits characteristics of a prominent payment system and therefore could be subject to Bank of Canada oversight.15 The vision for the other national retail payment systems is that they, too, would be subject to oversight that is proportional to risks. While newer retail systems are not systemically important or prominent, end-user protection is of particular importance. For instance, most collect information about users, which has commercial value. Safeguards should be in place to protect this information. See the Canadian Payments Act (S.C. 1996, c. 6, Sch.), available at laws.justice.gc.ca/eng/acts/p4.4/index.html. Users’ interests can be defined broadly to include service level expectations, convenience, ease of use, price, safety, transparency of terms of use, privacy and effective redress mechanisms. International standards for the oversight of systemically important payments systems are defined by the CPSS-IOSCO “Principles for Financial Market Infrastructures” (Committee on Payment and Settlement Systems and Technical Committee of the International Organization of Securities Commissions, April 2012). Prominent payment systems do not pose systemic risk but a disruption or failure could cause, on a national scale, significant disruption to the ability of consumers and businesses to make payments or a general loss of confidence in the overall payments system. The Bank of Canada could apply standards to prominent payments systems, based on the CPSS-IOSCO “Principles for Financial Market Infrastructures” (CPSS-IOSCO, April 2012). These standards would be adjusted so that they reflect the different nature and magnitude of the risks posed by prominent payments systems. BIS central bankers’ speeches Achieving the dual vision: private-public collaboration Now that I have sketched out the dual vision for the payments system in Canada and for its oversight, the next question is: How do we achieve it? A simple one-word answer would be: Together! In this context, “together” can have two meanings, but to be successful in moving toward this dual vision, both are important. Consumers, the payments industry and regulatory agencies all have an important stake in a well-functioning state-of-the-art payments system. All should be consulted. Finding the right solutions and the right balance will require collaboration from all those who have a role in reaching our vision. I trust you agree that forums such as this conference, FinPay,16 and the CPA’s Stakeholder Advisory Council should be leveraged for this purpose. In addition, public sector proposals for changing the regulatory and oversight landscape will go through a public consultation process that will allow constructive input from all stakeholders. Conferring together is important. So, too, is acting together. If the payments industry can adopt the same standards at approximately the same time, we can maximize the benefits accruing from the positive network effects associated with widely used standardized transactions. Achieving this will require three additional “c” words beyond consultation: namely, coordination, collaboration and co-operation. Clearly, the CPA and the public agencies are well placed to help coordinate and encourage collaboration and co-operation by industry. The CPA and its members can take the lead by embracing new technology to upgrade core clearing and settlement services to enhance efficiency and safety. The CPA has taken bold – and welcome – steps in this direction by promoting the adoption of the ISO 20022 standards and launching the Next Generation Clearing and Settlement System project. Using a common standard forms the foundation for any well-designed payment system. Standards such as ISO 20022 facilitate straight-through processing, enhanced business-tobusiness payments, interoperability, and faster funds transfers for end-users, both domestically and across borders.17 Adopting a common standard will also reduce the barriers that prevent new players from using core systems for clearing and settlement. To be truly successful and to benefit all Canadians, co-operation on the implementation of standards is essential. Giving consumers and businesses what they need and what they want is no easy task, but it is an inescapable one. Those who do not innovate will be left behind in today’s globally competitive world. FinPay is the Finance Canada Payments Consultative Committee, a forum of public and private sector representatives that advises Finance Canada on developments related to public policy aspects of the Canadian payments system. Consideration could also be given to the recommendation from the Task Force for the Payments System Review that a centralized digital ID initiative should be further explored as a catalyst to spur innovations such as mobile payments and to leverage e-commerce and the full capabilities of the digital economy. See Task Force for the Payments System Review, “The Way We Pay: Transforming the Canadian Payments System” (July 2011): 16. BIS central bankers’ speeches Conclusion Let me wrap up. Looking ahead, we all want to embrace technological change to improve the payments system in Canada and promote the economic and financial welfare of Canadians. For this purpose, we need a complementary dual vision to guide the changes in both the payments system and its oversight. Innovation is driving a rapid evolution – one that requires planning as pointed out more than 10 years ago by my former colleague, James Dingle. He wrote a short book about the history of the CPA titled, Planning an Evolution.18 If we were to write a similar book covering the next 20 challenging, but promising, years in the life of the CPA, we might want to modify the title somewhat to Planning a Revolution. When it comes to monetary policy, the Bank is committed to achieving our 2 per cent inflation target – the best contribution that monetary policy can make to keeping the Canadian economy on a sustainable growth path. In recent months, we have said that economic growth needs to become more balanced and broadly based, with more growth coming through exports and related business investment. Let me connect this with the vision for the payments system that I’ve described today: One of the ways we can promote trade-driven growth is to work with our trading partners to reduce substantially the costs of cross-border payments. And, of course, a well-functioning payments system is a crucial element of an efficient financial system, which is, in turn, a key ingredient of sustained economic growth. As industry and the public sector work together to improve our payments system, we will count on the CPA to continue to play a key role. At this pivotal point in time, we have a oncein-a-generation opportunity to shape the future of Canada’s payments system. And we should act on it. We look forward to continued dialogue and collaboration as our shared vision becomes reality. Thank you very much. J.F. Dingle, Planning an Evolution: The Story of the Canadian Payments Association, 1980–2002 (Ottawa: A joint publication of the Bank of Canada and the Canadian Payments Association, 2003). 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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 16 July 2014.
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Stephen S Poloz: Release of the Monetary Policy Report Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 16 July 2014. * * * Good morning. Carolyn and I are pleased to be here with you today to discuss the July Monetary Policy Report, which the Bank published this morning. Before we take your questions, let me take a minute to share our thinking around how our quarterly analysis of growth and inflation feeds into our monetary policy decisions. I’ll begin by reminding you that monetary policy must be forward looking. That’s because policy actions take time – around 6–8 quarters – to work their way through the economy and have their full effect on inflation. Let’s look back to last fall, when measured inflation was very low – total inflation was just 0.7 per cent last October, and core inflation was 1.2 per cent. Inflation had been running below target for some time and the economy was carrying a lot of excess capacity, which raised the risk that inflation could fall even further. At the time, even though we presented a projection in which the forecast risks around inflation were roughly balanced, we gave greater weight to the downside risks than the upside ones. Because inflation had been persistently below target, a negative shock would have mattered more than a positive shock, as inflation would have been driven even farther away from target. In short, we attached greater weight to the downside risks because inflation’s starting point was already relatively far from home, and had been for some time. This situation persisted during the winter months, but during the spring, inflation began to move up. Six weeks ago, when we last set the target for the overnight rate, the inflation numbers we were working with were April’s. They showed total CPI inflation at 2 per cent and core at 1.4 per cent. Although we had expected inflation to move up due to various oneoff factors, including the effects of last year’s decline in the dollar, the increases arrived a bit faster than we had presented in the April MPR. At our announcement date six weeks ago, we did not have a new projection in which to work out all the details and balance the forecast risks. The economy still had a significant degree of excess capacity, which acts to pull inflation down over time. Further, relative to our projection in the April MPR, we were monitoring growing downside risks on global economic activity. We believed that as we worked toward our next projection, published in today’s MPR, we would probably be downgrading the economic outlook. That would mean a longer period of economic slack in Canada, and would translate into a downside risk to inflation later in the forecast horizon. Accordingly, six weeks ago, even though measured inflation had already ticked up, and looked likely to tick up even more, we indicated that the downside risks to our inflation outlook remained as important as before. In effect, the risks associated with the starting point for inflation had diminished, but the downside risks to the underlying fundamental drivers of inflation were growing. Today, our Report notes that total CPI inflation has moved to 2.3 per cent, and core inflation to 1.7 per cent. This pickup in measured inflation is attributable to the temporary effects of higher energy prices, exchange rate pass-through and other sector-specific shocks. It is not coming from any change in domestic economic fundamentals. BIS central bankers’ speeches Today’s MPR presents a new economic projection in which there are both upside and downside risks to the inflation outlook. We believe these risks are roughly balanced. The downside risks to inflation associated with a below-target starting point have clearly diminished. The projection now includes a lower track for global economic activity, and a slower return of our economy to its full potential. Our serial disappointment with global economic performance for the past several years of course means that we remain preoccupied with downside risks to economic activity and the fundamental drivers of inflation. As the temporary effects pushing inflation up begin to dissipate during 2015, unless the economy’s slack is absorbed over a reasonable timeframe, inflation will drift back down well below target. This will require above-potential economic growth fuelled by rising exports, followed by investment in new capacity. We believe that the ingredients are present for an eventual return to balanced and sustainable growth, with inflation on target, in 2016. We are anticipating that global demand will strengthen and, with the lower Canadian dollar, indeed, will lead to a pickup in Canadian exports and business investment. We expect real GDP growth to average around 2 1/4 per cent during 2014 – 2016. The economy is expected to reach full capacity around mid-2016, a little later than we said in April. Meanwhile, household imbalances continue to evolve constructively and recent data are broadly consistent with a soft landing in Canada’s housing market. For the inflation target to be achieved on a sustained basis in 2016, the economy must reach and remain at full capacity. Closing the output gap over this time frame is reliant on continued stimulative monetary policy and hinges critically on stronger exports and business investment. Weighing these considerations within the Bank’s risk-management framework, the monetary policy stance remains appropriate and the target for the overnight rate remains at 1 per cent. The Bank is neutral with respect to the timing and direction of the next change to the policy rate, which will depend on how new information influences the outlook and assessment of risks. And now, with that, Carolyn and I would be pleased to answer your questions. BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Société de développement économique de Drummondville, Drummondville, Quebec, 16 September 2014.
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Stephen S Poloz: Float of the loonie Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Société de développement économique de Drummondville, Drummondville, Quebec, 16 September 2014. * * * Introduction Thank you for inviting me to be here with you today. It’s great to be back, but I guess you know I have changed jobs since I last saw you. Companies in this region have gone through very difficult times in the wake of the global financial crisis – as have many across Canada. We’re in a better place now, but our economy is still not back to normal. So I appreciate the opportunity to come and meet with you to understand your situation better and share with you what’s on my mind. As entrepreneurs, I’m sure you know that global trade has recovered only partially, as the world economy is still working through the fallout from the crisis. Compounding the issue for exporters, of course, has been the relative strength of the loonie. While it has come down in the past several months, it is still more than 40 per cent higher than it was in the early 2000s. Many people in this room may be wondering why the Bank of Canada did not do more to limit the appreciation of the loonie, or to weaken it after it rose. After all, we have said time and again that stronger exports are needed to bring our economy home. In my remarks today, I will do my best to answer that question. If I do my job well, you will leave with an understanding of why it’s a bad idea to try to manipulate exchange rates. I’ll give you some context and explain the role of the exchange rate in the Bank’s inflationtargeting framework. And I will talk about what we believe is needed to help our economy eventually return home, to balanced and sustainable growth. Targeting inflation: the Bank’s best contribution to Canada’s economic well-being The Bank of Canada’s mandate is to promote Canada’s economic and financial welfare. We do that by targeting inflation, as measured by the consumer price index. Our target range is 1 to 3 per cent, with the Bank’s monetary policy aimed at keeping inflation at the 2 per cent target midpoint. In pursuing this target, we set in place the necessary conditions for strong, sustainable economic growth. A low and stable inflation rate allows businesses and consumers to make financial decisions with confidence that the value of their money won’t be eroded by inflation. Parents can put money away to help their children with their education or for their own retirement without worrying that inflation will erase the real value of their savings. Businesses can plan expansions with reasonable forecasts of how inflation will affect what they will need for wages and investment. The benefits of inflation control are confirmed by history. Since the adoption of the inflationtargeting regime in 1991, inflation has averaged very close to target, economic growth has been more stable, and unemployment has been lower and less variable. And, at the height of the crisis, our inflation-targeting regime and the credibility we have garnered over the years helped us weather the storm. Riding the tides of the global economy Canada’s flexible exchange rate is an essential element of this monetary policy framework, as it helps us ride the tides of the global economy. BIS central bankers’ speeches Our economy is open to the rest of the world. It must be, for we depend on sales to other countries to support our standard of living. We have a diversified export sector, but we depend more on exports of resources than most other advanced countries. For that reason, our currency tends to move with commodity prices, which in turn move with rising or falling global demand. Indeed, we benefit from having a currency that rides the rising and falling tides of the global economy. It acts as a buffer. When the world economy is strong, commodity prices rise and our currency tends to float up to facilitate the adjustment of our economy. Similarly, when the world economy is weak, commodity prices fall, and our currency tends to float down. It’s like a floating breakwater across the mouth of a harbour that rises and falls with the tides, but absorbs the waves to help keep the water in the harbour calm. Without a freely floating currency, prices, wages and unemployment could fluctuate markedly, and that would create havoc for people and businesses. A flexible exchange rate is essential for us to be able to pursue an independent monetary policy in the interests of Canada. Let me illustrate with a “what-if?” scenario. Back in 2002, the Canadian dollar was worth around 65 cents U.S. By early 2008, it had risen to around parity. The world price of oil was about $25 per barrel in 2002, but by early 2008, that price had risen to well over $100. It would be hard to imagine the Canadian dollar staying in the mid-60-cent range, given the rise in oil prices. As I’ve said before, there is a loose but predictable relationship between oil prices and our currency – like a dog and its master, when connected by one of those leashes that stretch and rewind. But let’s just suppose we had tried to stop the Canadian dollar from rising once it reached around 85 cents, sometime in 2005. The obvious way to limit the rise in the dollar would have been for the Bank to cut interest rates. Given the underlying upward pressure on the dollar coming from rising oil prices, we estimate that holding the loonie at around 85 cents back in 2005 would have required cutting interest rates from 4 per cent to almost zero. As you would expect, the economy would then have two sources of stimulus – higher prices for oil exports and ultra-low interest rates, which would have boosted borrowing and spending. This combination would have overheated our economy during 2006–08, and inflation would have begun to rise above our target. We estimate that inflation would have been approaching 4 per cent by 2008. As an aside, let’s talk about what actually happened in 2008 – the global financial crisis. While it’s tricky to introduce a slice of reality into a hypothetical scenario, it is worth noting that if our interest rates were already near zero, we clearly would have had no room to manoeuvre. But let’s set aside that complication, and finish our “what-if?” scenario. By 2008, inflation would have been approaching 4 per cent and still be rising. Your companies’ costs of production would have been rising by 4 per cent or more, and export competitiveness would be eroding steadily, even though we would be holding the exchange rate steady at 85 cents. And that would not be the end of the story. With its anti-inflationary credibility increasingly at risk, the Bank would be forced into action – it would abandon its hypothetical attempt to control the dollar, interest rates would rise significantly to slow the excessive growth in the economy, unemployment would increase and inflation would eventually make its way back down to target. The exchange rate would have to find its own level at that point, because the Bank could not both target inflation and hold the exchange rate constant at the same time. BIS central bankers’ speeches Although this is just a counterfactual thought experiment, it is informed by hard analysis. Trying to hold the dollar constant would give us larger fluctuations in unemployment, output and inflation, and in the end would not help us maintain our international competitiveness. It would also mean that we would have less policy credibility when it came time to take action during the financial crisis. In short, by targeting the exchange rate, we would lose our ability to pursue an independent monetary policy in the interests of Canada. By the same token, we can imagine a scenario where the U.S. economy was picking up speed and our economy was lagging. In such a situation, U.S. interest rates might rise at a time when maintaining our inflation target would require that Canadian interest rates remain unchanged. If we were trying to hold the exchange rate unchanged instead of targeting inflation, we would probably need to match U.S. interest rate increases in lockstep; but doing so would risk pushing our inflation rate back below our target. Again, attempting to control the exchange rate would mean giving up our independent monetary policy. Now, none of this means that we are indifferent to exchange rate movements. In fact, we closely analyze the effects of exchange rate movements on the economy. Our aim, however, is not to achieve a specific value for the dollar. It is to achieve our inflation target. The best place for the exchange rate to be determined is in the markets. The markets trade the Canadian dollar toward a value consistent with the relative fundamentals of our economy and those of our trading partners. This trading happens around the clock, and new information is instantly taken into account by a multitude of participants. Markets are not perfect – they can overreact, or can break down in times of stress – but they are our best bet. Some have argued that the Bank can have it both ways: it can use interest rates to pursue its inflation target, but independently intervene in the foreign exchange market to achieve a more desirable level for the dollar. This means buying and selling Canadian dollars in exchange for U.S. dollars in the open marketplace. But, given the depth of the global market, the Bank would need to undertake truly massive transactions to have even small effects on the exchange rate. Those effects would be very short-lived and, in the attempt, thwart the good work that markets do for us every day. The only time when such direct intervention in markets might be practised would be in the case of a breakdown in the market, in which case the Bank could offer to transact on either side until normal trading resumed – in short, an emergency situation where the market fails for some reason. Still others have suggested that the Bank could offer the exchange market verbal guidance about what the value of the dollar should be. Behind this suggestion is a presumption that the Bank has a better understanding of the macroeconomic fundamentals driving the dollar than the market. This is a difficult claim to defend. Our exchange rate depends on a host of domestic and foreign fundamentals, many of which are beyond the Bank’s influence. Better that these myriad effects be weighed, debated and wrestled with in a deep marketplace than in a simple statistical model developed by the central bank. In short, I believe in markets. Manipulating or trying to guide them is just not in our game plan. What the Bank has done and will continue to do is be as clear as possible about how it sees the forces at play in the economy, and where the major sources of uncertainty and risks lie. To bring this uncertainty more into the policy dialogue, we have made some changes in the past year to how we analyze and talk about monetary policy. Our efforts reflect the fact that the business of central banking is being adapted in real time to the changing environment. We have begun putting our growth and inflation forecasts in the form of ranges rather than points, and have given even more prominence to uncertainty and risks in the Monetary Policy Report. We have refined our analysis of financial stability risks and raised the profile of our Financial System Review. And, we have begun to offer a more fulsome description of how those risks are entering our policy deliberations. These changes have brought more BIS central bankers’ speeches transparency to policy decision making, and our policy narrative has shifted from one traditionally seen almost as “mechanical engineering” to one now characterized as “risk management.” Getting home – a natural sequence Let’s talk about that policy narrative now. In the aftermath of the financial crisis, our export sector contracted significantly. The household sector picked up much of the slack in response to record-low interest rates, especially by investing in housing. But we cannot rely on policy-induced growth to maintain our living standards forever. The Canadian economy requires a major rotation toward a more sustainable growth track. First, we need a substantial recovery in exports, Canada’s natural engine of economic growth. From that will follow more investment spending by companies, accompanied by more employment growth. All of this will help absorb our spare capacity, bringing inflation sustainably to our target of 2 per cent. And along the way, there will be a gradual reduction in our financial stability risks, such as household imbalances. This is a natural sequence that we will monitor carefully. Its starting point, and the most critical ingredient, is a substantial recovery in exports. Where will that critical revival of exports come from? Well, energy exports are already leading the way. This is the main source of natural growth in our economy today – new energy exports, new investment, new jobs. Furthermore, higher oil prices are boosting incomes across the entire country, and that creates jobs, too. But growth in energy exports alone cannot make up for the loss of exports we have experienced since the crisis. Non-energy exports also will contribute, but they have been very sluggish for several years, at least until recently. After a weak start to the year, there has been a surge in non-energy exports in the past few months. About half of this rebound was weather-related, as exports were delayed during the winter. But underneath these fluctuations we are starting to see some early signs of recovery. The fact is, though, that the global economy remains an uncertain place and, as forecasters, we are wary of the serial disappointment it has delivered us in recent years. Europe is obviously the biggest question mark. Nonetheless, the U.S. economy appears to be back on track and is now showing signs of higher investment spending, which is usually associated with stronger exports of Canadian machinery and equipment, packaging materials, industrial materials, and business services. Many of these sectors are also sensitive to exchange rate fluctuations, so the lower dollar is providing an additional boost to foreign sales. Certainly, we should expect to see our forecast coming true right here in Drummondville, as this has always been an export-intensive part of the country. Companies here are investing to diversify their product lines and their customer bases and are positioning themselves for new growth. We now see the region’s traditional focus on textiles and furniture giving way to a broad range of technical, value-added manufacturing in machinery and equipment, building and packaging materials, and plastic and rubber products – some of the very sectors we expect to see leading our export recovery. Nevertheless, some other export sectors have been struggling since well before the financial crisis. For them, the restructuring road is proving long and difficult, so some of the lost ground may only be made up over an extended period of time. We can also expect to see brand-new export activity from newly created exporting firms. I’m sure I don’t have to remind this audience that many firms were wiped out in the crisis. Normally, as the economy gets back to full capacity, the overall population of businesses picks up and more firms enter the export markets, creating new products, new services and, most importantly, new jobs. Unfortunately, company population growth has been very BIS central bankers’ speeches sluggish since 2008, and preliminary data indicate this population did not increase at all in 2013.The ingredients are in place, however, so we remain hopeful that this process will resume in 2014–15. All things considered, then, we are cautiously optimistic about our exporting future. It will take more than a few months to establish a trend, and then still longer for it to translate into more investment and hiring by companies, but it looks like the natural sequence we’ve been hoping for is getting under way. Conclusion Let me sum up. It is simply not possible to have a fulsome discussion of the outlook for Canada’s inflation rate and our monetary policy without an understanding of the effects the exchange rate is having on the economy. But trying to control the loonie is off the table, as far as we are concerned at the Bank of Canada. A floating loon is a thing of beauty, and so is a floating loonie, at least from this economist’s perspective. Our job is to understand the context, and adjust short-term interest rates to meet our inflation target. That job is tough enough. It is the job of the market to watch the economic data unfold and grind out the implications for other financial markets, including the exchange rate, on a daily basis. That, too, is a tough job, but it is not ours. The fact is, the Bank can’t do its job well unless the market does its job well, and vice versa. And the Bank has been working to bring more transparency to the various elements of uncertainty that have been making its job more difficult, and this additional transparency is helping the market do a better job. And all that is more than just talk – it means that business people like you can do a good job, too. BIS central bankers’ speeches
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Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, to the SFA Society Toronto, Toronto, Ontario, 22 September 2014.
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Carolyn Wilkins: Monetary policy and the underwhelming recovery Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, to the SFA Society Toronto, Toronto, Ontario, 22 September 2014. * * * Introduction Good afternoon. Thank you for inviting me. I’m delighted to be here today with this group of accomplished investment professionals. What I will speak about today intertwines your professional world with mine. Let me start with what we’ve all observed: the recovery from the global financial crisis has been underwhelming, to say the least. It has left us debating what kind of growth we can reasonably expect after so much disappointment. It has also left us debating how central banks should conduct monetary policy without compromising financial stability. During the crisis, central banks and governments took unprecedented action. They worked together to prevent the failure of systemically important financial institutions, and to provide exceptional monetary and fiscal stimulus. These policies were successful in preventing the worst. But even this forceful policy response could not prevent a severe and protracted global recession. Massive amounts of wealth were destroyed. The values of equities and housing plunged. The loss to global output was roughly $10 trillion by the end of last year. All told, the crisis left the global economy with 62 million fewer jobs.1 The recovery has had repeated false starts and still faces considerable headwinds. Global growth has averaged only around 3 per cent over the past two years. That’s well below the average prior to the crisis, and it is unlikely that 2014 will be much better. Financial markets are reflecting these lowered expectations. That’s part of the reason why long-term interest rates in the major advanced economies, including Canada, are very low. Today I’m going to talk about three important matters for central banks. First, to conduct monetary policy, we need to know how much of this slow growth is cyclical and how much is structural. Second, to calibrate our policy we need to know how these factors, taken together, are affecting the neutral rate of interest. And third, making judgments about the impact of these factors is not an exact science. As you know, there is a lot of uncertainty. That is why we take a risk management approach to achieving our inflation target. Disentangling cyclical and structural factors So how much of this slow growth is cyclical and how much is structural? History teaches us that balance-sheet recessions such as the world has just seen are typically followed by growth that is much slower than in the wake of a normal recession. The legacy of a financial crisis is a heavy burden for any country, and paying down debt impedes normal economic growth for a long time.2 This makes the task of disentangling the cyclical from the structural more difficult, but it needs to be done in order to determine the rate of non-inflationary This estimation of job losses is relative to trend. See “Global Employment Trends 2014: The Risk of a Jobless Recovery,” International Labour Organization, Geneva, 2014. This pattern has been well documented by Harvard professors Carmen Reinhart and Kenneth Rogoff, among others. BIS central bankers’ speeches growth. As inflation targeters, the rate of potential output growth matters a lot to us. It is a critical input to the appropriate path for policy rates. Lost potential from the crisis Cyclical factors have clearly been playing a starring role in this underwhelming recovery. During the crisis, demand plummeted and so did output. As workers left the labour force and firms cancelled capital investments or went out of business, potential output growth declined as well. We are still facing headwinds from the deleveraging of households, fiscal consolidation and uncertainty. We estimate that potential output in Canada is about 3 per cent below where it would have been without the recession. That’s roughly $3,500 per household. In the United States, where the crisis hit harder, estimates of lost potential range from 5 per cent to 13 per cent – that’s US$6,500 to US$18,000 per household. Demographics and labour supply We also have structural factors weighing on potential. The population is aging, there are risks that some working-age people who left the labour market may not return, and there are concerns that technology is not going to deliver the leaps in productivity that we have seen in the past. Let’s start with demographic trends. Globally, over the next two decades, the number of people aged 65 and over will rise by more than 80 per cent, from 600 million to 1.1 billion. Canada is no exception to this trend. The baby boomers are starting to retire, and so the proportion of the population that is of working age is shrinking. Early retirement is also taking people out of the labour force. For Canada, this has subtracted about 0.45 percentage points from potential GDP growth over the last five years. A new wrinkle is that working-age people are also leaving the labour force. This was discussed at length last month by central bankers at Jackson Hole. The decline in the participation rate of young and prime age workers reflects the cyclical effects of a weak job market. But these cyclical effects could become structural. After a long search, if you don’t think you are going to find a job, at some point, you become discouraged and you stop looking. The longer you stay out of the labour force, the more likely it is that your skills have deteriorated and your attachment to the job market has weakened. This is what economists mean when we talk about hysteresis. Productivity growth We know that with a relatively smaller labour force, a nation’s capacity for growth will depend on the productivity and creativity of its workers and businesses. Trend productivity growth in advanced economies has declined over the past decade and a half – and Canada has lost ground compared with the United States and some other countries. Pessimists argue that the high rates of productivity growth seen in the post-war era or the late-1990s are history.3 Optimists say that technological progress in areas such as nanotechnology, computing and genetic engineering will once again generate strong productivity gains.4 At the Bank of Canada, we take a balanced approach when we factor all of this into our views on productivity. We expect business investment to pick up, which will lead to labour productivity growth that is a little higher than it was before the crisis. However, it will only be about two-thirds of its peak of around 2 per cent in the late 1990s. A similar decline is also expected to occur in the United States and the euro area. R. J. Gordon, “The Demise of U.S. Economic Growth: Restatement, Rebuttal, and Reflections.” J. Mokyr, “Secular Stagnation? Not in your life,” Chapter 6 in Secular Stagnation: Facts, Causes and Cures, a VoxEU.org Book edited by C. Teulings and R. Baldwin (London, UK: CEPR Press, 2014). Also Joel Mokyr’s comments on “Growth, Innovation and Stagnation”. BIS central bankers’ speeches Bottom line for potential The bottom line is that potential output growth in Canada and other industrialized economies will be lower than it was in the years leading up to the crisis. Our most recent estimate for Canada is that it will average just below 2 per cent over the next two years. This is a percentage point lower than average potential growth in the decade prior to the crisis. We will update this estimate in our next Monetary Policy Report in late October. We believe that some of the potential lost during the crisis will be restored through higher business investment and firm creation. But opinions vary on this. You may have read about a more extreme hypothesis, the idea of “secular stagnation.” This is the theory that there is chronically deficient demand in the global economy stemming from persistent headwinds and structural factors that predate the crisis. This is not the Bank of Canada’s baseline view. We expect the cyclical factors restraining growth to continue to dissipate over the next few years. We are already seeing the positive effects on growth in Canada and the United States. Implications for the neutral rate Let me turn now to what this all means for the neutral rate of interest.5 The gap between the policy rate and the neutral rate serves as gauge of the degree of monetary stimulus in the economy. It helps us to calibrate monetary policy. The neutral rate is to economists what dark matter is to physicists. We are convinced it exists, it plays a central role in our models and analysis, but we can’t directly observe it. So it’s important to be clear about the concept and the uncertainty around it. The neutral rate I am talking about here is the real risk-free rate of interest that enables the economy to operate at full capacity with stable inflation after cyclical forces have dissipated. It is the interest rate that generates just enough savings to finance investment in the long-run. Since savings can flow across borders, the neutral rate in Canada is influenced by both domestic and foreign factors. We posted on our website today a background paper on the neutral rate that lays this out very clearly. Let me walk you through the highlights. Real interest rates have fallen worldwide over the last few decades, including in Canada. Given this decline and with such low interest rates today, it is reasonable to think that the neutral rate is lower than in the past. There are a number of structural factors related to investment and savings that explain why. Currently, investment is being held back by weak confidence and uncertainty about demand. These are cyclical factors, and hardly surprising given the duration of the crisis. The structural undercurrent here, though, is about the speed limit of the global economy. With the lower expected growth in potential output that I just discussed, we can expect lower returns to investment. With lower returns, investment will be weaker than it otherwise would be. When firms are investing less, their reduced demand for funds puts downward pressure on interest rates. The financial crisis also appears to have had a persistent effect on the capitalformation risk premium. As Robert Hall points out, this helps to explain why high profits and low interest rates are not boosting investment to a greater extent.6 The notion of a natural or neutral rate of interest was first used by Knut Wicksell. See K. Wicksell, Interest and Prices: A Study of the Causes Regulating the Value of Money (London: Macmillan and Company for the Royal Economic Society, 1936; original edition published in Sweden in 1898). R. Hall, “Quantifying the Lasting Harm to the U.S. Economy from the Financial Crisis,” Hoover Institution and the Department of Economics, Stanford University, National Bureau of Economic Research Macroeconomics Annual, April 2014. BIS central bankers’ speeches At the same time, effective business credit spreads in Canada today are around 15 to 45 basis points higher than they were before the crisis. Wider spreads are likely to persist because of tougher financial regulations and other factors.7 The neutral rate is also being affected by the level of global savings, which has risen significantly in the last decade and a half. There are a number of factors at play, and they are expected to persist. For example, many emerging-market economies (EMEs), especially in Asia, are pursuing policies that contribute to high savings rates. At the same time, elevated oil prices mean large current account surpluses in many countries that export oil. These savings are being invested in advanced economy assets, especially those denominated in U.S. dollars. EME reserves have increased tenfold to US$8 trillion since 2000. New financial sector regulations are also reinforcing increased demand for safe assets in order to meet higher collateral requirements and liquidity buffers.8 All told, we think that the neutral rate of interest is lower than it was in the years leading up to the crisis because of these structural developments. We estimate that the real neutral policy rate is currently in the range of 1 to 2 per cent. This translates into a nominal neutral policy rate of 3 to 4 per cent, down from a range of 4 1/2 to 5 1/2 per cent in the period prior to the crisis. The neutral rate serves as an anchor for our models and analysis, but it is not a fixed beacon because the structural factors that influence it can change over time. Relative to this longer-term concept of neutral, the policy rate in Canada is stimulative.9 We need this stimulus to close the output gap and maintain inflation sustainably at target. But even with a closed output gap and inflation at target, the policy rate may not be at neutral. As long as the factors leaning on growth persist, a policy rate below neutral would be required to maintain inflation sustainably at target. In the absence of this policy stimulus, the output gap would reemerge and inflation would fall below target.10 Some of the headwinds appear to be dissipating, but there is considerable uncertainty about how long they will persist. Let’s not forget that advanced economies’ debt doubled from roughly 160 per cent of GDP to 320 per cent between 1980 and 2010, and will take a long time to unwind. In fact, the global savings rate is expected to increase over the next five years. A joint analysis by the Financial Stability Board and the Basel Committee on Banking Supervision attempts to quantify this adjustment. It suggests that a 3-percentage-point increase in banks’ common equity Tier 1 capital ratio would raise lending spreads by around 45 to 50 basis points. Estimates for Canada, prepared by the Bank of Canada, fall very close to this range. O. Blanchard, D. Furceri and A. Pescatori, “A prolonged period of low real interest rates?” Chapter 8, Secular Stagnation: Facts, Causes and Cures, a VoxEU.org Book edited by C. Teulings and R. Baldwin (London, UK: CEPR Press, 2014). Also see: J. Cruz Lopez, R. Mendes and H. Vikstedt, “The Market for Collateral: The Potential Impact of Financial Regulation,” Bank of Canada Financial System Review (June 2013): 45–52. Common global developments play a central role in determining longer-run neutral rates in all countries, but country-specific differences in structural factors do introduce some heterogeneity. Shorter-run concepts of neutral can differ even more because they are influenced by cyclical factors that can vary substantially across countries (for a discussion of alternative definitions of neutral rates, see Box 1 in Mendes, 2014). For example, using a shorter-run concept, Carney (2013) concludes that “the equilibrium real interest rate [in the U.K.] has been, and continues to be, negative.” Shorter-run definitions of neutral are more useful as normative measures of the currently warranted policy rate than as tools for gauging the degree of stimulus in the economy. Given the headwinds faced by the Canadian economy, shorter-run measures of neutral in Canada would currently be well below the 3 to 4 per cent range for longer-run neutral rates. This is reflected in the Banks’ policy stance. See R. Mendes, “The Neutral Rate of Interest in Canada,” Discussion Paper No. 2014–5, Bank of Canada 2014; and M. Carney, “The Spirit of the Season” (speech to The Economic Club of New York, New York, 9 December 2013). For a more detailed explanation, see Technical Box 2, Headwinds, Tailwinds and the Policy Rate, Monetary Policy Report, July 2011. BIS central bankers’ speeches As I said earlier, proponents of the secular stagnation interpretation of events believe that the factors restraining demand are a larger and more permanent feature of the global economic landscape. If they turn out to be right, the real neutral rate could actually be negative and monetary policy could be a lot tighter than we think it is. While we cannot completely discount this possibility, we believe that in Canada the real neutral rate is still positive and that, globally, monetary conditions are generally stimulative, although they vary across countries.11 Challenges for monetary policy Our estimates of potential and the neutral rate, and the models in which they are used, are critical inputs to our policy deliberations. They are not the end of the story, though. We also ask ourselves how various sources of uncertainty should influence these deliberations. And we clearly articulate the main upside and downside risks to our base-case outlook for inflation. That is what we mean when we talk about our risk-management approach to monetary policy. As the economy recovers and we get closer to full capacity, judgments about potential output and the remaining slack in the economy become more important. So do judgments about the neutral rate and the amount of monetary policy stimulus. Inflation could surprise on the upside if there were less slack and more monetary stimulus than we think. We watch developments in inflation carefully to distinguish between temporary and lasting effects. Fortunately, central banks have considerable experience dealing with inflation that is above target and can act quickly to rein it in. In fact, given household debt levels, we think that interest rate increases could have a larger impact than in the past. If inflation were to surprise on the downside and remain stubbornly below target, that could be harder to deal with. Given where the policy rate is today, there would not be much more conventional monetary policy could do. We have a greater appreciation of this risk now than we did before the global recession, when we were more concerned about the upside risks to inflation. If we were actually in a situation of secular stagnation, well, we would need to consider a different policy framework. One option that has been put forward would be to raise the inflation target in order to deliver negative real interest rates, since nominal interest rates can’t go below zero.12 Not only would we face the costs of higher inflation, we would also risk stoking financial imbalances.13 We are weighing the risks to financial stability posed by a low interest rate environment. We have made it clear that household imbalances are at the top of our list of vulnerabilities. But monetary policy is not the primary tool to address these risks. Regulation and supervision, The secular stagnation hypothesis posits that much of the current deficiency of demand is a structural feature of the economy. In order to explain why the structural deficiency of demand was not evident before the crisis, proponents of secular stagnation argue that it was masked by financially unsustainable growth prior to 2008. A more likely explanation is that deficient demand since the crisis has been due to deleveraging and uncertainty in many jurisdictions. In Canada, weak global demand is a more obvious explanation than secular stagnation. Moreover, the data suggest that as headwinds dissipate, growth is picking up and output gaps are closing in many economies, including Canada and the U.S. O. Blanchard, G. Dell’Ariccia, and P. Mauro, “Rethinking Macroeconomic Policy,” IMF Staff Position Note, 12 February 2010, SPN/10/03; P. Krugman, “Inflation Targets Reconsidered,” Draft Paper for ECB Sintra Conference, May 2014. Some, including DeLong and Summers (2012) and Summers (2014), have argued that stimulative fiscal policies should be used to raise demand and counter adverse hysteretic effects on potential output. See J. Bradford DeLong and L. H. Summers, “Fiscal Policy in a Depressed Economy,” Brookings Papers on Economic Activity (Spring 2012): 233–297; Also L. Summers, “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound,” Business Economics, Vol 49, No 2 (2014): 65–73. BIS central bankers’ speeches along with targeted macroprudential actions, are more effective lines of defence. These defences have been strengthened a number of times since 2008.14 Conversely, there are risks that a premature withdrawal of monetary stimulus could undermine the expansion. History provides us with a number of cautionary tales. A classic one is the tightening of monetary policy in 1937 that led the U.S. economy to falter as it emerged from the Great Depression.15 Monetary stimulus is important to the sustained recovery of demand and can potentially contribute to building supply by supporting investment in capital and increased labour force participation. Public policies such as structural reforms and fiscal stimulus play a more critical role. G-20 leaders have recognized the need to undertake measures to revive both demand and potential growth rates.16 Of course, decisions made by financial institutions, businesses and households are the most important determinants of our economic prospects over the long term. Conclusion To do our job right we need to judge how much of the underwhelming recovery is due to cyclical factors and how much to structural factors. The global economy continues to face headwinds associated with the balance-sheet recession. It also faces demographic changes, hysteresis in the labour market, and weak productivity growth. We aren’t buying the pessimistic view held by proponents of secular stagnation, although no one really knows how long the factors constraining demand are going to persist and how much damage they’ve done to global potential. Some countries have more baggage than others, so how long these factors persist will vary from country to country. But it is clear that potential growth rates in many economies are lower than they were prior to the crisis. Because of this, and given the high level of global savings, the neutral rate of interest is also lower. Our approach is to consider the main sources of uncertainty in our deliberations on how best to achieve our inflation target. This helps us avoid making big errors that are difficult to correct. When we do this, it is clear that continued monetary stimulus is needed to return the Canadian economy to sustainable growth and to maintain inflation at target. And, depending on the evolution of the data, it is possible that persistent headwinds will mean that some degree of stimulus will be required even after the output gap is closed to keep inflation at target. The Minister of Finance has tightened mortgage insurance rules, the Superintendent of Financial Institutions has developed stronger mortgage underwriting principles and the Canada Mortgage and Housing Corporation has improved its programs. G. Eggertsson, B. Pugsley, “The Mistake of 1937: A General Equilibrium Analysis,” Monetary and Economic Studies (Special Edition), Vol. 24, No s-1 (December 2006):151–190. At its summit in Sydney, Australia, in February 2014, the G-20 agreed to take measures to boost global growth by 2 per cent over the next five years, largely by removing impediments to growth such as product and labour market rigidities. BIS central bankers’ speeches
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Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, at Carleton University, Ottawa, Ontario, 24 September 2014.
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Timothy Lane: Are we there yet? The United States and Canada after the global financial crisis Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, at Carleton University, Ottawa, Ontario, 24 September 2014. * * * Introduction It is a pleasure to be here at Carleton University. It has been a long time since I was a student here, but I still get caught up in the back-toschool feeling of September. It’s a time of fresh starts and renewed energy. Today I would like to talk about the economies of the United States and Canada and how our economic ties are evolving as the recovery from the financial crisis of 2008–09 continues. I will discuss the impact on Canada of the Federal Reserve’s unconventional monetary policies, and how Canada will be affected as these policies are gradually brought back to normal. While there are risks associated with this process, the Bank of Canada sees it as a positive sign that the U.S. economy is experiencing its own fresh start and gaining renewed energy. Ties that bind ... sort of Let me start with the ties between the United States and Canada. We are more than neighbours; perhaps we are more like fourth-year roommates. Economically, we need each other and have strong links. Over the years, we’ve been through good times and bad. We live comfortably together, provided that we respect each other’s space. On the whole, having our fortunes linked with those of the United States works in Canada’s favour. Our businesses can take advantage of the opportunities of a much larger market. That means more jobs in Canada. But, over the past several years, we have also been reminded that these strong ties expose us to adverse forces in times of stress. The old cliché is that “when the U.S. sneezes, Canada catches a cold.” There is an element of truth to that adage, but it only goes so far. Our economies do not move perfectly in sync, partly because they are structurally different: most obviously, ours is much more reliant on natural resources. And despite the strong influence of the United States, as economic policy-makers in Canada, we have plenty of scope to follow a different path. To explore these ties – particularly as they relate to my own field, monetary policy – let’s take a closer look at the financial crisis of 2008–09, the subsequent worldwide recession and the bumpy recovery. First, I’ll talk briefly about how Canada’s experience through that period has been similar to, yet different from, that of the United States. Then I’ll elaborate on where we are now, the challenges facing policy-makers in the United States, and what they mean for Canada. Tales of a global recession The financial crisis, which started with an overheated and precariously financed U.S. housing market, did not just affect Canada – it triggered a worldwide recession. In 2008, the dramatic failure of Lehman Brothers was effective, if nothing else, in concentrating minds: the world looked into the abyss and took notice. In a historic display of consensus, the G-7 agreed to take whatever steps were required to stem the crisis. They lowered policy interest rates sharply (Chart 1) and in a coordinated BIS central bankers’ speeches manner; they flooded the financial system with liquidity to quell the panic; and they stood behind systemically important financial institutions. These aggressive and coordinated policy actions prevented a financial and economic collapse that could have rivalled the Great Depression. Nonetheless, they did not prevent a severe and protracted global recession, which led to a period of weak and uneven global growth that continues to the present day. Through the crisis and beyond, the Federal Reserve acted aggressively and unconventionally – first to stem the crisis and, later on, to support the recovery. Like other central banks, the Fed began by boldly lowering its standard monetary policy instrument, the federal funds rate, as low as it could go. With policy interest rates at their lower bound, the Federal Reserve also went to unusual lengths in providing forward guidance – communicating how long those rates would be likely to stay at their current level and, more recently, the factors that they would take into account in deciding when to start raising them. The Fed also innovated by introducing large-scale asset purchases (LSAPs), best known as quantitative easing, or QE. QE provides an injection of liquidity into a stalled economy through the central bank’s purchases of financial assets such as government bonds and mortgage-backed securities. These operations have had pervasive effects on financial markets – not only in the United States but globally. They work through a variety of channels, including by pushing down long-term interest rates and the external value of the U.S. dollar and pushing up the prices of risky financial assets such as equities (Chart 2). BIS central bankers’ speeches As a related effect, these operations by the Federal Reserve – together with the unconventional policies of central banks of other major economies – have pushed the volatility of financial assets down to near historically low levels (Chart 3). The resulting exceptionally buoyant financial conditions suggest that risk and vulnerability have increased in the financial system. But, during this period, returning the United States to sustained economic growth has been of paramount importance. While there was some concern that QE could have resulted in runaway inflation, that hasn’t happened. In fact, the U.S. economy remained weak and inflation mainly below the Federal Reserve’s target. That’s because QE was being carried out in the context of the widespread BIS central bankers’ speeches private sector deleveraging after the financial crisis; and, despite the unprecedented scale of the operations, it was still not enough to break the economy out of its post-crisis funk. Canada: innocent bystander? Here in Canada, we didn’t have a homegrown financial crash. While the Bank of Canada acted promptly and aggressively to provide liquidity to keep financial markets functioning, no banks had to be rescued and house prices didn’t plunge. This is not to say we were lily pure. In fact, in 2007, a specialized Canadian market collapsed – the market for non-banksponsored asset-backed commercial paper (ABCP). It was only through timely and forceful action by the public and private sectors that this situation was resolved without generating wider fallout. Nevertheless, the recession in Canada was painful. This was mainly because our exports collapsed. It’s not just that about three-quarters of our exports go to the United States, but also that they are linked to sectors of the U.S. economy, such as housing and business investment, that fared particularly badly in the recession. To get us through this period of very weak exports, we also relied on stimulative monetary policy. Like the United States and other advanced economies, we lowered rates to their “effective lower bound” – in our case, 1/4 per cent. Unlike the United States, we did not need QE, although we did provide forward guidance for our policy rate, itself a form of unconventional monetary policy, for the year following April 2009. Our financial system was more robust, so easy monetary policy was transmitted into expanding credit for Canadian households and companies. In contrast with the United States, we had a buoyant, albeit uneven, housing market through the recession and beyond. Another important factor is that natural resource prices remained at elevated levels, so our resource industries recovered quickly. These prices were supported by the strong growth in China and other emerging-market economies, which slowed down with the global recession but quickly picked up again. The resource economy powered ahead, boosting disposable incomes, employment, engineering investment and government revenues. Canada bounced back quickly. By late 2010, we had passed the pre-crisis peak in GDP and employment – we were out of the recovery and into the expansion. At the Bank of Canada, we saw a need to get interest rates off the floor and raised them in a series of steps to 1 per cent. But then we were in for a round of disappointments and challenges of our own. As Canada’s recovery unfolded, our economy became increasingly unbalanced. Our non-energy exports, after picking up quickly, stalled well below their pre-recession level (Chart 4). Economic growth became increasingly reliant on building more and more homes, mortgaged at rockbottom interest rates and driving up the indebtedness of Canadians to unprecedented levels (Chart 5). That source of growth was increasingly tapped out. And it built up vulnerabilities in our financial system, which could spell trouble down the road. Another disappointment was that, last year, even as the U.S. economy began to strengthen, Canadian non-energy exports did not pick up as expected. Why not? This is a puzzle we are much closer to understanding – but our understanding is still imperfect. I won’t dwell on this topic, as my colleagues have already said a lot about our weak export sector. 1 Suffice to say that weak exports have meant that Canada has had to rely on exceptional monetary policy stimulus for even longer than we expected. Our policy interest rate has stayed at 1 per cent since 2010. S. Poloz, “Float of the Loonie,” Speech delivered to the Société de développement économique de Drummondville in Drummondville, Quebec, on 16 September 2014. BIS central bankers’ speeches What effects did the Federal Reserve’s unconventional monetary policies have on Canada during this period? Our analysis indicates that, for Canada, their net effect has been positive. The Fed’s policies have pushed down our market interest rates and, by promoting U.S. growth, have added to the demand for our exports. On the downside, these policies may have been one of the factors putting upward pressure on the Canadian dollar. But, on balance, the effects have been positive for Canada. BIS central bankers’ speeches Morning in America? So where are we now, in this long process of getting back to sustained economic growth? The U.S. economy is in expansion, with the private sector taking the lead. The headwinds that came from deleveraging – consumers whittling away at heavy debt loads – are abating and the net worth of those consumers has improved markedly (Chart 6). And the process of fiscal consolidation – bringing the federal budget deficit down to a more sustainable level – is largely complete (Chart 7). BIS central bankers’ speeches But growth has remained fairly modest. It’s not quite clear why. Perhaps uncertainty about demand is still holding back business decisions and investment. Given the rocky road of the last few years, this is to be expected. While U.S. housing markets are reviving, they are following an uneven and uncertain path, and there is a lot of room for improvement. Home construction is well below its pre-recession level, and the excess housing stock has largely been depleted (Chart 8). Likewise, there is room for improvement in labour markets, which are a long way from normal. On average, about 200,000 net new jobs were created each month during the past three years. Unemployment, which spiked during the recession, has fallen by about 4 percentage points since its peak. How does Canada compare? Since Canada experienced a shorter recession, our labour market conditions did not deteriorate as much, and were also faster to recover. For instance, by January 2011, Canada had recovered the number of jobs it lost during the recession – whereas the United States only reached that point in May of this year (Chart 9). But since 2011, Canada has been creating new jobs at a much slower pace than has the United States. Similarly, our unemployment rate did not rise as much during the recession, but has been coming down more slowly – and, if measured in the same way, is now at about the same level as it is in the United States. In both countries, the unemployment rate does not fully capture the labour market slack. In both the United States and Canada, there are still elevated levels of long-term unemployment and involuntary part-time employment, while wage gains continue to be moderate relative to historical norms (Chart 10). And here, as in the United States, young people are having a hard time finding jobs, and many have dropped out of the workforce. Our comprehensive measure of labour market slack has shown less slack than in the United States, but the gap has been narrowing (Chart 11). BIS central bankers’ speeches In all, while the U.S. economy is improving, there have been bumps in the road, and there will be more as the expansion continues. BIS central bankers’ speeches What is the Fed doing? It is in this context that the Federal Reserve has been winding down its QE purchases and has signalled its plan to return gradually to a more normal monetary policy stance, starting sometime next year. The precise timing and pace of that exit will depend on how the economy is performing. Like most decisions, this involves a balancing of risks. Tightening monetary policy too early could plunge the economy back into recession. Moving too late could let inflation take off and require more tightening to get it back under control. It could also result in bigger financial imbalances which, later on, if they unwind, could throw inflation into another downdraft. A formal difference between the Federal Reserve and the Bank of Canada is the Fed’s “dual mandate” to promote the goals of maximum employment and stable prices. This is in contrast to the Bank of Canada’s monetary policy framework: a target of 2 per cent inflation. But this contrast between our inflation target and the Fed’s dual mandate is not as sharp as it seems. When inflation expectations are well anchored, bringing inflation sustainably to the target depends mainly on bringing the economy to its potential – in other words, closing the output gap. In assessing the output gap, conditions in the labour market are one of the main things we look at. Last week, the Fed reconfirmed that it will likely end its QE program at its next meeting in October. This means that the Fed no longer expects to be purchasing additional financial assets under that program, which it has been gradually tapering since last January. The next challenge for the Fed is how to unwind the various other elements of unconventional monetary policy stimulus, which include ultra-low interest rates, a large volume of excess reserves in the financial system and a large Federal Reserve balance sheet (Chart 12). The composition of that balance sheet (e.g., government bonds of different maturities, mortgage-backed securities) may also matter. When is it time to start to reverse these policies? What are the right pace and sequence for each element? BIS central bankers’ speeches A key step in normalizing policy will be to start increasing the target for the federal funds rate, which is currently still in a range of 0 to 1/4 per cent. This can be accomplished, in part, by gradually raising the interest rate the Fed pays on excess reserves. The Fed will also remove excess reserves from the financial system, in order to control shortterm interest rates. They have introduced and test-driven an overnight reverse repo facility that they will use for that purpose. Restoring the Federal Reserve’s balance sheet to its normal size is a process that is likely to be accomplished over a longer period. It is important to note, however, that the size of its balance sheet will not hinder the Fed’s ability to control the policy rate and liquidity in the economy. The framework they have outlined will limit the risk that large excess reserves could lead to excessive loan creation and a sharp increase in inflation. Does this sound complicated? Yes – because it is complicated. But we have full confidence in our colleagues at the Federal Reserve to manage this process well. How will the renormalization of monetary policy play out in the financial system – both in the United States and globally? Asset prices, risk spreads and volatility are at levels that reflect the abundant liquidity provided through unconventional monetary policies in the United States and some other countries, together with expectations that interest rates will be kept at very low levels for a long time. While the Federal Reserve will seek to guide the renormalization process so that markets readjust smoothly as monetary policy is brought back to normal, there is an important risk that there will be some bumps along the way. What will the exit mean for Canada? On the whole, the Federal Reserve’s planned exit from unconventional monetary policies is part of a good news story for Canada. It is a sign that a sustained U.S. expansion is well under way. A more sustained U.S. expansion – a stronger housing market and robust business investment – should help our non-energy exports, which remain below their prerecession level. As the U.S. economy regains vigour, it should also contribute to improved business and consumer confidence in Canada. BIS central bankers’ speeches However, from a policy-maker’s perspective, the renormalization of U.S. monetary policy will act to tighten Canadian monetary and financial conditions. The same analysis indicating that QE had stimulative effects on Canada should also work in reverse: unwinding unconventional policies will tend to push up market interest rates in Canada and dampen the U.S. expansion. This effect would only be partly offset by the downward pressure the exit would put on the value of the Canadian dollar. In the event that the Fed’s renormalization does not play out smoothly in financial markets, the impact on Canada could be significant. So how will all of this influence what the Bank of Canada would do? You can probably already anticipate my answer: “It depends.” The Bank of Canada’s goal is to achieve our 2 per cent target for inflation in a sustainable way, which requires that our economy run close to its full potential. We will need to assess the various countervailing effects in the context of Canadian economic and financial conditions more generally. Like the Fed, we will balance the risks of acting too soon and stifling burgeoning economic growth against the risks of acting too late and letting inflation overshoot and fuelling imbalances in our housing markets. But that balance of risks is likely to be different here than in the United States. Thus, while monetary policy in the United States has an important impact in Canada, I want to stress that Canadian monetary policy is independent and can diverge from the Fed’s policies. In fact, our policy rate is already higher than the Fed’s as a result of the moves we made four years ago in response to the improving economic conditions at that time. Looking forward, as always, our rate decisions will depend on the state of the Canadian economy. Preserving the value of money by keeping inflation low, stable and predictable is our mandate. Are we there yet? Let me conclude. The financial crisis of 2008–09 reminded us how tightly linked the U.S. and Canadian economies are – for better or for worse. And the economic recovery has shown us that healing after a financial crisis is slow and often painful. The steps taken by the U.S. Federal Reserve, the central bank closest to the epicentre of the crisis, prevented the crisis and subsequent recession from being much worse. And they continue to support the U.S. and global economies through that long healing process. The Fed’s unconventional monetary policies affected Canada through various channels, notably by pushing down market interest rates worldwide. By the same token, as Fed policy returns to normal – which is likely to be a different state than before the crisis – that will tighten financial conditions in Canada. But this will be happening against the backdrop of stronger economic growth. It’s another step away from the dark days of the Great Recession and an affirmation that the hard work of economic reconstruction over the last six years is taking hold. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 22 October 2014.
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Stephen S Poloz: Release of the Monetary Policy Report Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 22 October 2014. * * * Good morning. Carolyn and I are pleased to be here with you today to discuss the October Monetary Policy Report (MPR), which the Bank published this morning. As I’ve said in the past, the policy decision is not a mechanical one, so I’d like to provide some colour around the issues we are dealing with. I would also like to highlight some advances in our thinking since the last MPR. Our outlook for the global economy continues to show stronger momentum in 2015 and 2016, but the profile has been downgraded since July. The good news for Canada is that the U.S. economy is gaining traction, particularly in sectors that are beneficial to Canada’s exports. And our exports do appear to be responding, with some additional help from a lower Canadian dollar. Our conversations with exporters indicate that they are seeing a better export outlook from the ground. However, it is clear that our export sector is less robust than in previous cycles. Last spring, as you may recall, we identified which non-energy subsectors could be expected to lead the recovery in exports, and which would not. We have since investigated in more detail the subsectors that have been underperforming. After sifting through more than 2,000 product categories, we have found that the value of exports from about a quarter of them has fallen by more than 75 per cent since the year 2000. Had the exports of these products instead risen in line with foreign demand, they would have contributed about $30 billion in additional exports last year. By correlating these findings with media reports, we could see that many were affected by factory closures or other restructurings. In other words, capacity in these subsectors has simply disappeared. This analysis helps us understand a significant portion of the gap in export performance. Our research also tells us that most of the sectors expected to lead the non-energy export recovery still have some excess capacity. Our Business Outlook Survey (BOS) interviews indicate that while companies plan to invest in new machinery and equipment, few are planning to expand their capacity, at least so far. This helps explain why business investment might be delayed relative to what would be expected in a normal cycle. This research has important implications for Canada’s employment picture. We know that when companies restructure or close their doors, the associated job losses are usually permanent. If companies can meet increased export demand with existing capacity, the associated employment gains can be fairly modest, with most of the increase in output coming in the form of higher productivity. The bigger employment gains will come when we enter the rebuilding phase of the cycle – when companies are sufficiently confident about future export demand that they begin to invest in new capacity and create new jobs. These considerations enter into our estimation of the output gap – the difference between GDP and potential GDP – which is the key macroeconomic determinant of the outlook for underlying inflation. When the economy is operating with excess supply, inflation declines, and when operating with excess demand, inflation rises. There is no single preferred measure of excess supply in the economy. Traditionally, we have put the most weight on measures based on output, or GDP. Each October, we do a full BIS central bankers’ speeches analysis of the determinants of potential output, and its future trend. We have done so in this MPR, but in future we will do this in every MPR. This time, we also offer a special technical box that considers the dynamics of excess capacity in longer business cycles like this one. The reason this is important is that in such longer business cycles, the restructuring or closure of firms reduces potential output while creating permanent job losses. This means that the output gap can appear smaller than the labour market gap, which is our current situation. This difference persists until the rebuilding phase of the recovery I discussed earlier, after which the excess capacity measures eventually converge. Our judgment is that we have considerable excess capacity and that continued monetary stimulus is needed to close the gap and bring inflation sustainably to target. But we take account of our uncertainty around the degree of slack by considering a range of possible slack estimates in our deliberations. Another important building block of our policy framework is the neutral rate of interest. Carolyn discussed this in an important speech last month; there is also a discussion paper about it, and a box in this MPR. The neutral rate, too, is uncertain. We estimate that it now lies between 3 and 4 per cent, which is well below pre-crisis levels. But since the difference between current rates and the neutral rate is our best estimate of monetary stimulus, understanding the risks around this is also important. After weighing these considerations, it is our judgment at this time that the risks around achieving our inflation objective over a reasonable time frame are roughly balanced. Accordingly, we believe that the current level of monetary stimulus remains appropriate. Some of you may be wondering why we aren’t being more specific about the likely future stance of monetary policy. Let me answer by saying that forward guidance remains a key element of the policy tool kit – but one that we will reserve for times when we believe there are net benefits to its use. There will no doubt come a day when we will offer forward guidance again – but not this day. And with that, Carolyn and I would be pleased to answer your questions. BIS central bankers’ speeches
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Speech by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Senate Standing Committee on Banking, Trade and Commerce, Ottawa, Ontario, 29 October 2014.
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Stephen S Poloz: Opening statement before the Senate Standing Committee on Banking, Trade and Commerce Speech by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Senate Standing Committee on Banking, Trade and Commerce, Ottawa, Ontario, 29 October 2014. * * * Good afternoon, Mr. Chairman and committee members. I am pleased to introduce you to Carolyn Wilkins, who assumed the post of Senior Deputy Governor of the Bank of Canada on 2 May of this year. Before we take your questions, let me give you some of the highlights of the economic outlook. I’ll draw mainly on the October Monetary Policy Report (MPR), which the Bank published last week, but I’ll also reflect back a bit further since it has been some time since we last met. I’ll touch on some new advances in our thinking, and talk about how the environment is driving an evolution in the way central bankers conduct monetary policy. Our outlook for the global economy continues to show stronger momentum in 2015 and 2016, but the forecast profile has been downgraded since July. The good news for Canada is that the U.S. economy is gaining traction, particularly in sectors that are beneficial to Canada’s exports. And our exports do appear to be responding, with some additional help from a lower Canadian dollar. Our conversations with exporters indicate that they are seeing a better export outlook from the ground. However, it is clear that our export sector is less robust than in previous cycles. Last spring, as you may recall, we identified which non-energy subsectors could be expected to lead the recovery in exports, and which would not. We have since investigated in more detail the subsectors that have been underperforming. After sifting through more than 2,000 product categories, we have found that the value of exports from about a quarter of them has fallen by more than 75 per cent since the year 2000. Had the exports of these products instead risen in line with foreign demand, they would have contributed about $30 billion in additional exports last year. By correlating these findings with media reports, we could see that many were affected by factory closures or other restructurings. In other words, capacity in these subsectors has simply disappeared. This analysis helps us understand a significant portion of the gap in export performance. Our research also tells us that most of the sectors expected to lead the recovery in nonenergy exports still have some excess capacity. Our Business Outlook Survey interviews indicate that while companies plan to invest in new machinery and equipment, few are planning to expand their capacity, at least so far. This helps explain why business investment might be delayed relative to what would be expected in a normal cycle. This research has important implications for Canada’s employment picture. We know that when companies restructure or close their doors, the associated job losses are usually permanent. If companies can meet increased export demand with existing capacity, the associated employment gains can be fairly modest, with most of the increase in output coming in the form of higher productivity. The bigger employment gains will come when we enter the rebuilding phase of the cycle – when companies are sufficiently confident about future export demand that they begin to invest in new capacity and create new jobs. These considerations enter into our estimation of the output gap – the difference between GDP and potential GDP – which is the key macroeconomic determinant of the outlook for BIS central bankers’ speeches underlying inflation. When the economy moves into a position of excess supply, inflation declines, and when it moves into a position of excess demand, inflation rises. There is no single preferred measure of capacity in the economy. Traditionally, we have put the most weight on measures based on output, or GDP. Each October, we do a full analysis of the determinants of potential output, and its future trend. We have done so in this MPR, but in future we will update this analysis in every MPR. This time, we also offer a special technical box that considers the dynamics of excess capacity in longer business cycles like this one. The reason this is important is that in such longer business cycles, the restructuring or closure of firms reduces potential output while creating permanent job losses. This means that the output gap can appear smaller than the labour market gap, which is our current situation. This difference persists until after the rebuilding phase of the recovery I discussed earlier, when the excess capacity measures eventually converge. Our judgment is that we have considerable excess capacity and that continued monetary stimulus is needed to close the gap and bring inflation sustainably to target. But we take account of our uncertainty around the degree of slack by considering a range of possible slack estimates in our deliberations. Another important building block of our policy framework is the neutral rate of interest. The neutral rate is the rate of interest that should emerge once all the dust has settled – inflation is on target, the economy is operating at its full capacity, and all shocks have been worked out. Carolyn discussed this in an important speech last month; there is also a discussion paper about it on our website and a box in this MPR. The neutral rate, too, is uncertain. We estimate that it now lies between 3 and 4 per cent, which is well below pre-crisis levels. But since the difference between current rates and the neutral rate is our best estimate of monetary stimulus, understanding the risks around this is also important. After weighing these considerations, it is our judgment at this time that the risks around achieving our inflation objective over a reasonable time frame are roughly balanced. Accordingly, we believe that the current level of monetary stimulus remains appropriate. Just as our analysis of the economic forces has been evolving with events as they transpire, so is the way we conduct monetary policy adapting in real time to the changing environment. There is now particular emphasis on the incorporation of uncertainty into policy decision making. We published a discussion paper on the subject earlier this month. We have begun putting our growth and inflation forecasts in the form of ranges rather than points, and have given even more prominence to uncertainty and risks in the MPR. We’ve refined our analysis of financial stability risks and raised the profile of our Financial System Review. And, we have begun to offer a more fulsome description of how those risks are entering our policy deliberations, particularly in the opening statement that precedes our press conferences. These changes have brought more transparency to our decision making, and our policy narrative has shifted from one traditionally seen almost as “mechanical engineering” to one now characterized as “risk management.” One powerful risk management tool that policy-makers have in their tool kit is forward guidance – the ability to provide to markets more certainty about the future path of interest rates. This effectively takes uncertainty out of the market and places it firmly on the shoulders of the central bank. There are costs as well as benefits to using this tool, and so we have decided that forward guidance will be reserved for times when we believe the benefits to its use are clear – periods of market stress, periods when traditional monetary policy tools are constrained, and so on. Otherwise, we will let markets do their job, which is to deal with the daily flow of new information and grind out new pricing, without specific interest rate guidance from the Bank, but supported by the increased transparency around our outlook for inflation and the risks we are managing. And with that, Carolyn and I would be pleased to answer your questions. BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Canadian Council for Public-Private Partnerships (CCPPP), Toronto, Ontario, 3 November 2014.
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Stephen S Poloz: The legacy of the financial crisis – what we know, and what we don’t Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Canadian Council for Public-Private Partnerships (CCPPP), Toronto, Ontario, 3 November 2014. * * * Introduction I am delighted to be here with you today, thank you. I applaud the Council’s efforts to foster stronger partnerships between the public and private sectors in the development of infrastructure, which is absolutely critical to our economic future. I’ll speak today from the perspective of a monetary policy-maker, whose mandate also is to contribute to the economic and financial well-being of Canadians. I’d like to talk about two subjects today: what we know, and what we don’t know. I’m sure it won’t be a surprise that the first part will be shorter than the second part. My goal is to help you understand better the risks that we face. If I do my job well, I’ll leave you with a sense of how the Bank weighs the known and the unknown when setting monetary policy. What we do know Let’s start with what we do know about our current situation. Most of us acknowledge that it all began with a period of exceptionally strong global economic growth in the mid-2000s, some creative financial engineering, an explosion of leverage and a speculative bubble that touched a lot of markets. The bubble burst when the U.S. housing market rolled over and some significant financial vulnerabilities were laid bare. The ensuing global financial crisis in the fall of 2008 was truly dire. Monetary policy and fiscal policy were quick to respond around the world, with collective G-7 and G-20 announcements on Thanksgiving weekend that year. Since then, we’ve seen policy rates near zero in several countries and an unprecedented use of unconventional monetary policy, including quantitative easing. We will never know how bad things would have been without that aggressive, coordinated policy response. But as a student of economic history, I can say that all the ingredients of a second Great Depression were present. We’ve managed to avoid that extreme scenario, but the damage wrought by the Great Recession has been brutal nonetheless. By the end of last year, the loss to global output from the crisis was roughly US$10 trillion, which is close to 15 per cent of global GDP. Today, there are over 60 million fewer jobs around the world than had the crisis not occurred. Still, memories of that near-disaster are fading, and today people are wondering why our policies have so far failed to foster a true global recovery, one that is natural and selfsustaining. The G-20 has acknowledged this disappointing growth outlook, and has set out a plan to collectively boost global GDP by 2 per cent over the next five years. Success will hinge on such policy actions as reforms to improve the functioning of labour markets, international trade liberalization and investment in infrastructure – your favourite area – just to name a few. These things are clearly worth doing, and that boost to global GDP will be worth having. BIS central bankers’ speeches What we don’t know Even so, when we see a world economy that is growing this slowly, despite the fact that interest rates are at historic lows, it is natural to ask some pretty basic questions. So, let’s turn now to what we don’t know. Let me focus on three questions that people have been asking me of late. First, what is preventing a full-fledged global economic recovery? Second, will there be any permanent damage to the economy due to the crisis and its aftermath? And third, by trying so hard to improve our situation, are policymakers simply sowing the seeds of the next financial crisis? What is preventing a full-fledged economic recovery? If interest rates are at zero or nearly zero, it follows that something is holding the economy back. Think of paddling a kayak against a strong headwind – it can take a lot of effort just to hold your position, let alone make real progress. It is widely agreed that the conditions that led to the financial crisis included taking on excessive leverage. As individuals and financial institutions have attempted to deleverage in the wake of the crisis, economic growth has been held back. It is difficult to say when the deleveraging process will be complete, at least at the global level. To illustrate, in the United States, private sector deleveraging was painful and swift as people cut back on debt and walked away from their over-mortgaged, devalued houses. In Europe, in contrast, this process is less well advanced, while in Canada, households continue to add to their debt loads. Another headwind has come from governments, which responded to the global recession with additional fiscal stimulus. As the situation stabilizes, though, it is natural for governments to aim to bring their fiscal situation back into balance. This reversal of fiscal stimulus creates a headwind for the economy as a whole, masking the private sector recovery that is happening underneath. Again, the status of this headwind varies from country to country, but it is clearly in play at the global level. The third, and probably the most important, headwind is lingering uncertainty about the future, whether from geopolitical developments, market volatility or just the trauma that companies have been through. Some people look at companies with strong balance sheets and wonder why they are not investing. Some have suggested that we have too much risk taking in financial markets, but not enough risk taking in the real economy. But that’s not what we’re hearing from the companies we talk to here in Canada. In this uncertain economic climate, companies actually feel like they are taking a lot of risk. And until the recovery is more certain, especially in export demand, for many, it is too risky to expand their businesses. What that seems to mean is that the expected risk-adjusted rate of return on a new investment can appear low to a company, and we can settle into a temporary lowconfidence/low-investment equilibrium, even when borrowing costs are extraordinarily low, until uncertainty subsides and confidence returns. It seems to me that we must allow for the possibility that the combined effects of deleveraging, fiscal normalization and lingering uncertainty will continue to restrain global economic growth for a prolonged period. We are confident that these headwinds will dissipate in time, but in the meantime interest rates will remain lower than in the past in order to work against those forces. Will some of the post-crisis economic damage be permanent? Still, it is important to acknowledge that global economic growth is simply not heading back to the high rates we saw before the financial crisis. For one thing, those rates were boosted by unsustainable leverage. For another, we have entered the retirement window for the post2 BIS central bankers’ speeches war baby boomers, and that means that global economic capacity is moderating as growth in the workforce slows. In Canada, for instance, potential economic growth has drifted down to around 2 per cent and will remain there for the next few years. Globally, potential growth is probably down to around 3 to 3 1/2 per cent. Both figures are lower than before the crisis. But this modest deceleration in global growth potential is a natural consequence of demographics, not the product of the crisis. The more important question is whether any of the problems we see today will become permanent. This question is relevant at the global level, but let me illustrate it with direct reference to our own situation here in Canada. Historically, a typical recession/recovery cycle has taken a couple of years to complete. During the recession – let’s say it originates with a drop in export demand – companies cut back production, lay off workers, and investment and consumption spending fall. Monetary and fiscal policies respond, exports recover, companies rehire their workers and move production back to normal. But this cycle has not been a typical one. The downturn was deep and has proved to be long lasting. Canada’s export sector not only cut back on production and laid off workers, many companies restructured, many simply disappeared. Recent Bank of Canada research on exporters sifted through more than 2,000 categories of underperforming, non-energy exports. We found that the value of exports from about a quarter of them has fallen by more than 75 per cent since the year 2000. Had the exports of these products instead risen in line with foreign demand, they would have contributed about $30 billion in additional exports last year. By correlating these findings with media reports, we found that many were affected by factory closures or other restructurings. Obviously, not all of this can be blamed on the financial crisis and the ensuing downturn, but for companies that were already struggling with competitiveness, the crisis surely accelerated things. The point is, when companies downsize, relocate or close their doors, the effects on the economy are permanent. Those specific lost exports will not recover – something else is more likely to take their place, but that requires that surviving companies expand, or new exporting companies be created. And both such processes are bound to be much slower than in the typical recession/recovery scenario. A destructive downturn also creates long-lasting effects in our labour market, since the associated jobs are lost permanently. We have recovered well from the employment losses during the downturn, but our labour market has not yet returned fully to normal. Indeed, labour conditions in Canada point to material slack in the economy. We have been creating jobs at a trend rate of less than 1 per cent, well below what one would expect from an economy that is recovering. Furthermore, much of the recent employment growth has been part time. There are over 900,000 people in Canada who are working part time but would prefer to be in full-time positions, and total hours worked are barely growing at all. And then there are the young people who are out of work, underemployed or trying to improve their job prospects by extending their education. We estimate that there are around 200,000 of these people, and I bet almost everyone in this room knows at least one family with adult children living in the basement. I’m pretty sure these kids have not taken early retirement. The good news is that these destructive effects should be reversible over time. Once we have seen a sustained increase in export demand, uncertainty about the future will diminish and firms will respond. Our research indicates that many of the export sectors that we expect to lead the expansion still have some excess capacity to meet higher demand. This is one reason why our productivity growth has picked up recently – firms are responding with what they have, and job creation has remained modest. But once those capacity limits are reached, exporting firms will begin to rebuild their production capacity with new investments BIS central bankers’ speeches and job creation will pick up. Those same conditions will be ideal for fostering new firm creation, and as we all know, new companies create a disproportionate share of new jobs. The implication is clear: a sustained expansion in our exports not only will represent new demand, it will ignite the rebuilding phase of our business cycle, which will create new supply. This virtuous cycle continues until the excess capacity in the labour market is reabsorbed. By our estimation, it will take around two years for us to use up our excess capacity, at which point inflation will be sustainably at our target. In the meantime, continued monetary stimulus is needed to keep the process in motion, and if the headwinds discussed earlier persist, continued policy stimulus may still be needed to offset them even after our excess capacity has been absorbed. Are we simply sowing the seeds of the next financial crisis? To summarize to this point, the global headwinds that are preventing a return to natural, selfsustaining growth remain considerable, and some of the damage already experienced in our economy will be long lasting. On the positive side, though, our conservative assessment is that global momentum is building, Canada is beginning to benefit, and with the assistance of continuing monetary stimulus, we can return to natural growth at full capacity over the next two years. This leads to my third question: Is all of this monetary stimulus simply sowing the seeds of the next financial crisis? The side effects of aggressive and prolonged monetary stimulus are well known – it promotes excessive risk-taking in financial markets and excessive borrowing by individuals. These are the very ingredients that led to the 2008 financial crisis in the first place. Accordingly, this question merits a serious response. To begin, we knew back in 2008 that stimulative monetary policies would encourage people to borrow more to buy more homes and cars. That is why we do it – to buffer the downturn in the economy. This happens in every business cycle, not just this one. What distinguishes this cycle is its duration, which is leading to a buildup of financial stability risks over time. We study these risks in detail in our Financial System Review, which is published twice a year. The next issue will be released on 10 December. Importantly, the world has changed since 2008. A key commitment of the G-20 in 2008 was to strengthen the global financial system. That work is very well advanced, and the system is far better capitalized and more resilient today. Furthermore, there have been a variety of macroprudential policy changes that have made the system safer. Here in Canada, for example, we have strengthened the rules around the mortgage market in several ways. Those changes, combined with very high-quality underwriting even before those changes were made, make the Canadian situation very different from what we saw in the United States just before the crisis. That being said, some critics would still say that we are running the risk of creating the next financial crisis through our actions. I might ask in response: What is it you would have us do, then? As the central bank, we only have one real channel of influence, which is to set short-term interest rates. Right now, we are providing monetary stimulus sufficient to bring inflation sustainably to our target within a reasonable time frame, around two years from now. To argue that we should instead set interest rates in a way that reduces financial stability risks, then, is clearly a call for higher interest rates. Let’s walk through a thought experiment together. What would our world look like today if, instead of keeping interest rates low to stimulate the economy, both Canada and the United States had moved their policy rates back up to neutral at the beginning of 2011? We BIS central bankers’ speeches estimate that the neutral rate of interest today is between 3 and 4 per cent for Canada, and use a similar number for the United States, so our thought experiment is to raise rates to about 3 1/2 per cent in both countries. Such a move would of course allow those headwinds we talked about earlier to blow us backwards. We estimate that, under this hypothetical scenario the output gap in Canada would have been around 5 1/2 per cent today, instead of around 1 per cent. Unemployment would have been around 2 percentage points higher than it is today, and core inflation would be running somewhere between 0 and 1 per cent. Most of the impact would be felt in reduced housing construction and renovation and auto production, as these were the sectors that responded to the policies put in place after the crisis. Moreover, these estimates do not capture the range of confidence effects that would permeate the rest of the economy under such a difficult scenario, so the story could even be worse. From this monetary policy-maker’s perspective, that’s an unattractive alternative. Our primary job is to pursue our 2 per cent inflation target, with a degree of flexibility around the time horizon of its achievement; that flexibility permits the Bank to give due consideration to financial stability risks, provided they do not threaten macroeconomic performance. Currently, inflation is close to target, but some of its strength is due to temporary factors, such as increases in prices for meat, electricity and telecommunications, and the passthrough of past exchange rate depreciation. Unless the output gap closes as expected over the next two years, inflation will drift back down significantly below 2 per cent as the temporary effects of these factors wear off. Meanwhile, financial stability risks are clearly on our radar. In particular, housing activity is showing renewed momentum and consumer debt levels are high, so household imbalances appear to be edging higher. But it is our judgment that our policy of aiming to close the output gap and ensuring inflation remains on target will be consistent with an eventual easing in those household imbalances. Accordingly, we judge that the overall risks of attaining our inflation target over a reasonable time frame fall into the zone of balance at this time. Conclusion Let me conclude. I have put a lot of emphasis today on the things we don’t know. But it is important to underscore that we have a wide range of tools, some of them very sophisticated and others as simple as having conversations with Canadian companies, to help us reach judgments on those issues. The Bank’s approach to policy is evolving in light of these developments. We have made some major advances in our thinking in the past year, and in the transparency with which we present these issues to you. Many of the key variables that are essential to the policy decision – measures of capacity, the neutral rate of interest, our outlook for growth and inflation, and so on – are now conveyed in ranges. These elements of uncertainty are being explicitly incorporated into our decision making. All of this demands that we think of monetary policy as an exercise in risk management. Although we regard the risks around attaining our inflation target over a reasonable time frame to be balanced, as policy-makers, we acknowledge that, in the current situation, the consequences of an upside risk would be more manageable than those associated with a downside risk. If this makes central bankers seem overly preoccupied with downside risks, and seem gloomy to you, then take heart – we are just doing our job. BIS central bankers’ speeches
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Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, at the Wilfrid Laurier University, Waterloo, Ontario, 13 November 2014.
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Carolyn Wilkins: Money in a digital world Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, at the Wilfrid Laurier University, Waterloo, Ontario, 13 November 2014. * * * Introduction I am happy to be back here in Waterloo to speak with you today about money in a digital world. I am also honoured to be your first economist-in-residence for a day. When I was a student at Wilfrid Laurier in the 1980s, I started every day with a coffee, and I bought that coffee with cash. That’s when coffee cost less than a dollar and long before I had a credit card. And I picked up extra cash working as a waitress at Wilf’s. Many things haven’t changed much since then – many of you must pick up a coffee on the way to class or catch up with friends at Wilf’s. What has changed, though, is how we pay for things. It’s fascinating the way technology and consumer preferences are pushing the boundaries of how we define and use money. The Bank of Canada is paying close attention to e-money, given that our job is to issue currency, promote financial stability and oversee Canada’s payment systems. Today I’ll cover three points. First, I’ll start with a brief historical perspective. Money and associated means of payment have changed over the years, but it seems never as fast as they are changing today. Second, to get a sense of proportion, I’ll talk about how e-money is currently being used relative to other payment options like cash or debit. Finally, I’ll talk about the benefits and risks of these innovations. This matters to you because e-money is not just about how you pay for things. It’s also about the financial risks you face if you use it. It matters to the Bank because of the potential over time for e-money to alter the fundamental payments architecture in Canada and around the world. Money and payments have come a long way When you look at history, money and payment systems reflect the societies they serve – and like societies, they have been transformed by technology. The image you see above, is a painting by Canadian artist Blair Ferguson. It hangs in one of the Bank of Canada’s meeting rooms. The reason I’m showing it to you is because it illustrates how money has changed BIS central bankers’ speeches throughout history. At one time, playing cards served as money, as well as cowrie shells, cocoa beans, gold and, eventually, bank notes and coins. None of these objects, except for the gold and cocoa beans, has any meaningful inherent value. They are money because people accept them as money. For this to happen, money must do three things. First, money must serve as a medium of exchange: you pay tuition; you receive an education in exchange. The alternative is bartering, but that is complicated and inefficient. Second, money must serve as a store of value. When you work during the summer you need to be confident that every dollar you earn is still going to be worth a dollar when it comes time to pay your tuition. Finally, money must serve as a unit of account, which you need in order to compare prices – like comparing the value of the new BlackBerry with other mobile devices on the market. The form of money we know best is bank notes. They were issued primarily by commercial banks in Canada and the United States before those countries created central banks in the early 20th century. These privately-issued bank notes ultimately failed to provide what the economy needed and so central banks were given this responsibility. The Bank of Canada has been issuing bank notes since 1935. 1 The cash you have in your wallets perfectly meets the three criteria of money. It is accepted almost everywhere, there’s very little counterfeiting, and the issuer – the central bank – won’t go bankrupt. We also target inflation, which means that the internal value of money is predictable. Since we started issuing bank notes, there has been a parade of non-cash options introduced to our payments system. They’ve been driven by technology and consumer demand for efficient ways to pay for things. In the 1970s, credit cards were leading edge – around the same time that Pink Floyd and Led Zeppelin dominated the music scene. In the 1990s, debit cards were the new big hit. The next leap in innovation was e-transfers and online banking services. Payments are even quicker now with contactless credit and debit cards. Last month, Apple Pay became the latest player in this game. So we’ve come a long way since cocoa beans. Yet all these payment innovations can be used only if you have a bank account. The vast majority of Canadians have access to banking services, but that’s not the case in many developing countries. That’s part of the reason why non-banks are coming up with innovative electronic payment methods that we generically call digital currency or e-money. E-money can be defined broadly as monetary value stored electronically, on a phone or a card, or in the cloud. It’s a digital alternative to cash, and it’s a stored value that is not linked to a bank account. There are two types of e-money that I want to talk about today. The first type is denominated in a national currency, and it represents a claim on the issuer. In Canada, there are a number of examples. There are PayPal balances, and there are stored-value cards that use the Visa or MasterCard networks. 2 These types of e-money store value and can be used to buy a lot of things. The safety of this type of money really depends on the credibility of a trusted third party. This is because you’re trusting Visa or PayPal to safeguard your balance and to validate and authenticate your transactions. The second type of e-money is cryptocurrency – such as Bitcoin. This type of e-money is not denominated in any national currency and so has its own unit of account. It is also completely decentralized and does not represent a claim on the issuer. This is the There was a gradual phase out of commercially-issued bank notes that lasted over a decade. Rich discussions of this period are available in Powell (2005) and Bordo and Redish (1986). Gift cards and store-specific cards are not considered e-money because they are not accepted by businesses other than those that issued them. BIS central bankers’ speeches revolutionary part of cryptocurrencies – transactions can be validated without a trusted third party. The way they achieve this is by using cryptography to ensure that each transaction is valid and secure. Trusted third parties are needed for other functions, however. You may want help to keep track of your virtual wallet and these currencies are not redeemable for national currencies. People generally trade them through an online exchange at the market rate. Bitcoin was introduced in 2009. Five years later, there are more than 500 other cryptocurrencies – Ripple and Litecoin and I could go on. 3 Even though only a few of them ever really do any trading, they continue to develop and innovate. E-money still a wallflower in Canada E-money is still a wallflower in developed countries where many people have bank accounts, although this could change quickly. Today it is more popular in countries where relatively fewer people have access to banking services. 4 An example of this is Kenya, where many people use e-money called M-Pesa. M-Pesa is backed by the issuer and redeemable in the Kenyan shilling. It gives people a low-cost way to transfer money using their mobile phones. M-Pesa is used in some 2 million transactions each day, worth about $5 billion annually. That’s nearly 20 per cent of Kenya’s GDP. Limited access to banks is not always the main motivator for the adoption of e-money. The Octopus card, in Hong Kong, was originally designed to pay for public transit. It proved so convenient that it is now used for over 13 million transactions each day – from transit to coffee to a pair of jeans. Canadians seem to be less enthusiastic about e-money, and there appears to be little demand for something like the Octopus card. We are nonetheless big users of e-payment methods that give us access to credit or our bank accounts. Almost all Canadian adults have debit cards, and more than 80 per cent have at least one credit card. 5 Over half of all transactions in Canada use debit or credit cards. At the same time, we still use a lot of cash, even if the proportion is falling over time. The total value of cash holdings in Canada as a share of GDP has been relatively stable for the past 30 years. There are good reasons for this. Cash is fast, convenient and costs virtually nothing to use. It is anonymous, so you don’t have to worry about exposing personal information to potential criminals, although for this reason cash is also used in the underground economy. People also hold onto cash as savings for a rainy day. Bank of Canada research suggests that changes in cash management practices could also help explain the constant demand for cash. 6 So let’s talk now about cryptocurrencies. Some Canadians appear intrigued by Bitcoin – the very first Bitcoin ATM in the world was installed in Vancouver just over a year ago. And as of last July, a quarter of the world’s Bitcoin ATMs were found in Canada. There’s one here, in Kitchener-Waterloo. There are also about 340 Canadian merchants who say they accept Bitcoin, and about 76,000 merchants accepting Bitcoin in other parts of the world. Some merchants may be accepting it, but it has yet to gain much traction with people making purchases. There aren’t a lot of data on this, but what we do have indicate that last year there were around 70,000 Bitcoin transactions per day across the globe. This pales in While Bitcoin is the dominant cryptocurrency, there are many others: Dogecoin, Ethereum, Peercoin, and Darkcoin to name just a few. The World Bank estimates that about 2.5 billion people do not have access to banking services. Henry, Huynh, and Shen (2014). Jiang and Shao (2014). BIS central bankers’ speeches comparison with the more than 21 million debit and credit card transactions that occur each day in Canada alone. Things can change fast when it comes to adoption of new technology. At the Bank of Canada we’ve done some experiments in behavioural economics to look at what elements determine the success or failure of e-money. 7 What we find is that adoption of e-money is exactly like the tango – it takes two. Buyers need to decide whether to use the new payment method while sellers need to decide whether they’ll accept it. It turns out that it’s the seller’s side that leads the dance; if there is a large enough fraction of sellers accepting new payment methods, more and more buyers are prompted to use them, eventually leading to complete adoption on both sides. In the case of Bitcoin, not many people want to dance. This is because it has serious flaws when it comes to satisfying the three main characteristics of money. While a number of merchants may be accepting Bitcoin, there is still a big risk that if you acquire bitcoins you won’t be able to find someone to accept them later when you want to spend them. There’s also no getting around the fact that cryptocurrencies are very volatile and therefore unreliable as a store of value. Bitcoin’s value relative to the U.S. dollar has gone from pennies to over $1,100 and then back down to $300 in just four years. It is not surprising then that Bitcoin and other cryptocurrencies are not acting as a unit of account. Businesses are still pricing products in national currencies and converting to a cryptocurrency at the checkout. For these reasons, the Bank of Canada views Bitcoin and other cryptocurrencies as investment products rather than money. 8 And we are not alone. The Canada Revenue Agency considers digital currencies as a commodity that can be bought and sold. That is why any resulting gains or losses could be taxable income that must be reported. 9 Bank of Canada has its eye on developments E-money is not big enough to pose material risk to financial stability in Canada at this time. That said, money and payments technology is progressing in leaps and bounds, and so the Bank of Canada is watching developments closely. The federal government also is undertaking a review of payment systems in Canada to ensure that the degree of regulation of payment systems and methods is appropriate. This review has resulted in the Bank of Canada having increased responsibility to oversee payment systems of economic and systemic importance. There is little doubt that these innovations have some benefits. They give us more choice about how we make purchases, and can reduce the cost of certain transactions. Think about online purchases of pictures or songs. The transaction costs of traditional payment methods, such as credit cards, make these small-value purchases expensive. A $1 transaction could be done for no fee using Bitcoin while it could cost over 30 cents in fees using some merchant credit cards. E-money is also useful for sending money across borders. Traditional financial institutions offer these services, called remittances, but the fees can be as much as 10–12 per cent for small transactions. So, e-money has some benefits in certain economies, especially when cash is not a viable option. 10 Those who use cryptocurrencies may also like the privacy they offer. These transactions require little or no exchange of personal information. However, people often overestimate Arifovic, Duffy, and Jiang (2014). Gandal and Halaburda (2014). http://www.cra-arc.gc.ca/nwsrm/fctshts/2013/m11/fs131105-eng.html. Chiu and Wong (2014). BIS central bankers’ speeches how anonymous Bitcoin really is. It is not as anonymous as cash, and all Bitcoin transactions are public in the open source ledger, and so they can be linked to a specific IP address. 11 This means that the user could be identified eventually. There are risks to using e-money. People need to be aware of the risk of putting their trust in an e-money scheme that is lightly regulated with limited or no user protection. For example, debit cards are linked to deposit accounts that are insured by the government and held in banks that are closely regulated. Balances stored with PayPal or other e-money providers do not have those protections. Aside from posing risk to individual users, it is also a level playing field issue for Canadian banks. Users of cryptocurrencies are even more vulnerable. While cryptocurrencies do not require a trusted third party to authenticate and validate transactions, they still require users to put their trust in numerous private businesses, such as exchanges and Bitcoin wallets. This leaves them exposed to theft, fraud and loss. The biggest example is the failure of Mt. Gox, which resulted in hundreds of millions of dollars in losses. And while these problems could happen with other forms of e-money, cryptocurrencies offer little recourse because the legal status of the players is still quite ambiguous. The list of issues doesn’t end there. Crypotocurrencies can be used for money laundering, terrorist financing, and other criminal activities. 12 That is why governments around the world are building a new legal framework for cryptocurrencies. For example, Canada has introduced legislation to require cryptocurrency exchanges to register and to report suspicious transactions that may be linked to money laundering and terrorist financing. Regulators in the state of New York are proposing to issue a “BitLicense” to protect consumers, prevent money laundering and enforce cyber security. Some countries, like China, have ruled that financial institutions cannot handle any Bitcoin transactions. If e-money were to gain widespread acceptance in an economy, there would be implications for the central bank. The Bank of Canada earns money by issuing currency. This profit is called seigniorage. The bank notes that we issue cost very little to print, and we invest the balance of their value in Government of Canada securities that earn interest. With this profit, But it’s not just about seigniorage. Some people have wondered whether widespread use of e-money could impair the ability of the central bank to conduct monetary policy. This is very unlikely because Canadian interest rates would still matter. 13 Whether they use e-money or cash, as long as people and businesses pay bills and borrow in Canadian dollars, the Bank of Canada would still be able to achieve its monetary policy objective. When it comes to cryptocurrencies, however, the situation is different. In the unlikely situation in which cryptocurrencies were used broadly, a significant proportion of economic transactions would not be denominated in Canadian dollars. This would reduce the Bank’s ability to influence macroeconomic activity through Canadian interest rates. Let me be clear, we are nowhere near this point today. But if we were, it would be even more important to determine whether issuing e-money is a role that should be done by the central bank. If e-money denominated in Canadian dollars were to significantly replace bank notes, there are some options that the central bank could take so as to be in a position to intervene in markets or be the lender of last resort. The ledger and the protocol that enables it can be applied widely. For example, a peer-to-peer messaging system – Bitmessage – has been built that could be a secure replacement for email. A recent paper by the European Banking Authority listed some 70 risks inherent in cryptocurrencies. Fung, Molico, and Stuber (2014). See also Friedman (2000) and Woodford (2000, 2003) for a broader discussion. BIS central bankers’ speeches Another important issue is the potential for e-money to fundamentally change the financial architecture in ways that we don’t yet understand but that could pose risks to financial stability. Think about a crash in a cryptocurrency as an example. If the cryptocurrency were widely-used, the economic and financial implications of such a crash would be significant because they would result in a dramatic reduction in household wealth. 14 A crash or failure of one type of e-money can be a concern even if the e-money is not widely used. This is because the failure of one issuer could result in a loss of confidence in other issuers and in the payments system more generally. That is why the Bank of Canada sees risks to the economy in a structure that would allow the benefits of money issuance to accrue to the private sector while any losses would be borne by the government and taxpayers. Let’s remember, these issuers are getting the equivalent of seigniorage but have limited or no oversight at this time. The history I mentioned earlier also gives us an important lesson. period that we refer to as the “free banking era” in the United States – when private banks were issuing bank notes and trying to ensure their value. The notes of some banks faced steep discounts, outright runs and there were a string of crises in the banking system. 15 These crises prompted governments to step in to insure bank notes issued by private banks. It ushered in the national banking era with a lot of regulation, supervision and government intervention. 16 It came as no surprise then, that central banks were eventually given the sole responsibility for issuing bank notes. Conclusion Money and means of payment have come a long way since then. E-money and the technology that enables it are circumventing our old models of payment and fast creating new efficiencies and new risks. This matters because it affects the risks faced by people who use e-money and it has the potential to affect risks to the Canadian financial system as a whole. That is why the federal government, with the Bank’s help, is modernizing our oversight frameworks for payments. The Bank is also undertaking research on the potential merits of issuing e-money. Individuals need to be aware of the risks of using e-money that is not subject to minimum oversight and consumer protection standards. We also need to be aware that cryptocurrencies can be used for money laundering and terrorist financing, which is why governments around the world, including Canada, are finding ways to monitor their use. Money and payments are at the core of central banking. The Bank of Canada is working through the tough issues today so that we can support the benefits of innovation, while safeguarding the integrity of Canada’s money and payment systems and, ultimately, financial stability. References: Ali, R., J. Barrdear, R. Clews and J. Southgate. 2014. “The Economics of Digital Currencies.” Bank of England Quarterly Bulletin 54 (3): 276‒86. Arifovic, J., J. Duffy and J. H. Jiang. 2014. “An Experimental Study of the Adoption of a New Payment Method.” Bank of Canada Working Paper, forthcoming. Ali, Barrdear, Clews, and Southgate (2014). Weber (2014a). Weber (2014b). The U.S. experience with private bank notes was worse than the Canadian experience, mainly because the U.S. banking system was more fragmented. BIS central bankers’ speeches Bordo, M. and A. Redish. 1986. “Why Did the Bank of Canada Emerge in 1935?” NBER Working Paper 2079. Chiu, J. and T.-N. Wong. 2014. “E-Money: Efficiency, Stability and Optimal Policy.” Bank of Canada Working Paper No. 2014–16. European Banking Authority. 2014. “EBA Opinion on ‘Virtual Currencies’.” European Banking Authority Opinion 2014/08. Friedman, C. 2000. “Monetary Policy Implementation: Past, Present, and Future – Will Electronic Money Lead to the Eventual Demise of Central Banking?” International Finance 3(2): 221–27. Fung, B., M. Molico and G. Stuber. 2014. “Electronic Money and Payments: Recent Developments and Issues.” Bank of Canada Discussion Paper No. 2014–2. Gandal, N. and H. Halaburda. 2014. “Competition in the Cryptocurrency Market.” Bank of Canada Working Paper No. 2014–33. Henry, C. S., K. P. Huynh and Q. R. Shen. 2014. “2013 Methods-of-Payment Survey Report.” Bank of Canada Discussion Paper, forthcoming. Jiang, J. H. and E. Shao. 2014. “Understanding the Cash Demand Puzzle.” Bank of Canada Working Paper No. 2014–22. Powell, J. 2005. “A History of the Canadian Dollar.” Ottawa: Bank of Canada. Weber, W. E. 2014a. “The Efficiency of Private E-Money-Like Systems: The U.S. Experience with State Bank Notes.” Bank of Canada Working Paper No. 2014–15. ―――.2014b. “The Efficiency of Private E-Money-Like Systems: The U.S. Experience with National Bank Notes.” Bank of Canada Working Paper, forthcoming. Woodford, M. 2000. “Monetary Policy in a World Without Money.” NBER Working Paper No. 7853. ―――2003. “Interest and Prices: Foundations of a Theory of Monetary Policy.” Princeton, NJ: Princeton University Press. BIS central bankers’ speeches
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Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Calgary Chartered Financial Analyst (CFA) Society, Calgary, Alberta, 18 November 2014.
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Agathe Côté: Inflation targeting in the post-crisis era Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Calgary Chartered Financial Analyst (CFA) Society, Calgary, Alberta, 18 November 2014. * * * Introduction Thank you for the invitation. I am pleased to be here. One of my main responsibilities at the Bank is overseeing the analysis of domestic economic developments in support of monetary policy decisions. It is always very helpful to meet the people and visit the places behind the economic trends we are tracking. My speech today is about inflation targeting. It might be difficult to imagine now, but back in the 1980s, interest rates on mortgages topped 20 per cent. That, of course, was before we signed a pioneering inflation-control agreement with the federal government in 1991. Canada was the second country in the world – after New Zealand – to adopt an inflationtargeting regime. It is not often you can say that a product worked better than advertised. Inflation targeting has. It has easily exceeded our expectations. Since 1991, inflation in Canada, as measured by the consumer price index (CPI), has averaged 2 per cent, and its variability has fallen by roughly two-thirds. Canadians have benefited in a number of important ways. Greater price stability has allowed consumers and businesses to manage their finances with more certainty about the future purchasing power of their savings and income. Real and nominal interest rates have also been lower across a range of maturities. As a result of these developments, low, stable and predictable inflation has encouraged more solid economic growth and a well-functioning and more stable labour market. In addition, our inflation-targeting regime provided both a beacon and an anchor as we navigated the global financial crisis. The inflation-targeting agreement is renewed with the federal government approximately every five years. The agreement sets the inflation objective at 2 per cent – the midpoint of a 1 to 3 per cent target range – and gives the Bank effective independence for achieving it. It was last renewed in 2011. We view these periodic reassessments as an essential element of our commitment to good governance. With the next renewal set for 2016, I want to talk to you today about the key issues that we reviewed in 2011, major developments since then and outstanding questions that we will be analyzing over the next two years. I want to emphasize at the outset that nothing’s broken. Our flexible inflation-targeting regime has served Canadians well, both in calm and turbulent times. So the bar for change is high. Where we were in 2011 In the run-up to the 2011 renewal, the Bank focused its research on three questions: whether to adopt a lower inflation target; whether to move to price-level targeting; and how monetary policy should take account of financial stability considerations. These questions were not new. But the global financial crisis cast them in a different light. BIS central bankers’ speeches Let me outline where the Bank came out on each of these three questions in order to give you some context for the discussion that follows about our current research. 1 Should we target a lower rate of inflation? Canada, like most other inflation-targeting central banks in advanced economies, has been aiming at an inflation target of 2 per cent. Why 2 per cent? We know that high and variable inflation is costly. It erodes purchasing power, creates uncertainty, distorts relative prices and investment decisions, and causes arbitrary redistributions of wealth between savers and borrowers. So the inflation target should be low enough to minimize these distortionary effects. At the same time, there are risks associated with very low rates of inflation, the most important being the zero lower bound (ZLB) on interest rates. The lower the inflation target, the lower the average nominal policy interest rate will be. Therefore, the greater the likelihood that adverse shocks will push interest rates to the ZLB and hence limit the central bank’s ability to respond with conventional policy. A positive inflation rate also helps to “grease the wheels,” since it is less likely that the economy will be constrained by downward nominal wage rigidity. 2 Another argument for a slightly positive inflation target is that official price statistics are subject to measurement bias, in effect, overstating true inflation. 3 Would there be net benefits to targeting an inflation rate lower than 2 per cent? A lower target is intuitively appealing, since even with 2 per cent inflation, the price level doubles every 35 years. A lower target could further reduce distortions stemming from incomplete indexation of nominal contracts and the tax system, and the disincentives for holding money. The Bank’s research leading up to the 2011 renewal strengthened the case for lowering the target. However, our research and the experience of the crisis also highlighted the sizeable risks associated with the ZLB. While unconventional monetary policy (UMP) instruments, such as asset purchases and forward guidance, appeared to provide stimulus, their benefits and costs would only be known in the fullness of time. Our research indicated that encounters with the ZLB should be quite rare with a 2 per cent target, but were much more likely to occur with a target below 2 per cent. The Bank therefore concluded that the benefits of a lower inflation target were insufficient to justify the increased risk of being constrained by the ZLB. Should we move to price-level targeting? The second question we addressed was whether there would be net benefits to adopting price-level targeting (PLT). The distinguishing feature of price-level targeting is that, unlike For more detail on the 2011 renewal, see www.bankofcanada.ca/wp-content/uploads/2011/11/ background_nov11.pdf. See also M. Carney, “A Monetary Policy Framework for All Seasons” (speech to the U.S. Monetary Policy Forum, New York, NY, 24 February 2012), and M. Carney, “Renewing Canada’s Monetary Policy Framework” (speech to the Board of Trade of Metropolitan Montreal, Montréal, Quebec, 23 November 2011). The lower the inflation target, the more likely it is that nominal wages will occasionally need to decline to facilitate economic adjustment. If workers are reluctant to accept these declines, the process of real adjustment in the labour market will be impeded. While there is some evidence of downward nominal wage rigidities in Canada, Crawford and Wright (2001) conclude that their effects do not appear to be economically significant. See A. Crawford and G. Wright, “Downward Nominal-Wage Rigidity: Micro Evidence from Tobit Models,” Working Paper No. 2001–07, Bank of Canada, 2001. Others, however, have argued that this could be an important issue. See, for example, P. Fortin, “The Macroeconomics of Downward Nominal Wage Rigidity: A Review of the Issues and New Evidence for Canada,” Centre Interuniversitaire sur le Risque, les Politiques Économiques et l’Emploi, Working Paper 13–09. The measurement bias is estimated to be around 0.5 per cent in Canada. See P. Sabourin, “Measurement Bias in the Canadian Consumer Price Index: An Update,” Bank of Canada Review (Summer 2012): 1–11. BIS central bankers’ speeches inflation targeting, bygones are not bygones. Past inflation misses must be corrected. For example, following a period of below-target inflation, policy would seek a period of abovetarget inflation to ensure the desired rate of change in the price level over time. In addition to providing greater price-level certainty over the long run, PLT could reduce the volatility of output and inflation through automatic, self-correcting changes in inflation expectations. This could be particularly useful at the ZLB. However, for PLT to work, people need to be forward looking and the policy well understood and credible. In the end, the Bank concluded that, under ordinary circumstances, the expected benefits of PLT would be too small to justify the risks of abandoning our existing well-understood policy objective. How to address financial stability considerations? The crisis made it clear that price stability and financial stability are inextricably linked and that pursuing the first without regard for the second risks achieving neither. Indeed, low, stable and predictable inflation and low variability in activity can breed complacency among financial market participants as risk taking adapts to a perceived new equilibrium. The critical question this poses for policy-makers is whether monetary policy should lean against a buildup of financial imbalances. Monetary policy influences markets and the leverage of financial institutions so broadly that it cannot easily be avoided. As former Federal Reserve Governor Jeremy Stein once put it, monetary policy “gets in all of the cracks.” 4 This makes monetary policy an inappropriate tool to deal with sector-specific imbalances, but a potentially valuable one for addressing economy-wide imbalances. However, we concluded that monetary policy should be our last line of defence. It should be preceded by responsible behaviour by individuals and institutions and by effective micro- and macroprudential regulation and supervision. These defences should go a long way to mitigate the risks. Still, in some cases, monetary policy may have a role to play. This is most obviously the case when financial imbalances affect the near-term outlook for output and inflation. In exceptional circumstances, particularly if imbalances and excessive risk taking are widespread or encouraged by a low interest rate environment, monetary policy might have to be used even if it means that inflation would deviate from target for an extended period of time. Our credible inflation-targeting framework facilitates this flexibility while remaining perfectly consistent with ensuring long-run price stability. So, let me sum up our review preceding the last renewal. After considerable research and discussion, the Bank concluded in 2011 that our existing framework was robust and the right tool for delivering price stability and enhancing the economic welfare of Canadians. What we are focusing on now How have things changed since then? What have we learned, and what are the issues that we will be researching ahead of the 2016 renewal? The optimal inflation target – 2 per cent under increased scrutiny Experience and analysis since the 2011 renewal has reinforced our view of the importance of the ZLB. At the same time, interest rates are likely to be lower, on average, in the future than J. C. Stein, “Overheating in Credit Markets: Origins, Measurement, and Policy Responses” (speech at the Research Symposium, “Restoring Household Financial Stability After the Great Recession: Why Household Balance Sheets Matter,” sponsored by Federal Reserve Bank of St. Louis, St. Louis, Missouri, 7 February 2013). BIS central bankers’ speeches they were before the crisis. As a consequence, ZLB episodes could become more frequent. Together, these factors suggest that consideration should be given to an inflation target that is above 2 per cent. In recent years, global economic growth has repeatedly fallen short of expectations. For many advanced economies, this means that the ZLB has been a more enduring constraint on monetary policy than anticipated. This is not to say that central banks are powerless at the ZLB. In fact, a growing body of evidence suggests that UMPs have had a positive impact on economic activity and inflation. 5 That said, it is still unclear to what extent UMPs can effectively substitute for conventional monetary policy. As well, there are potential issues associated with the use of UMPs, such as risks to central bank independence and complications related to exit. Our research will aim to shed additional light on the ability of UMPs to mitigate the effects of the ZLB. The lessons we draw from recent experience with the ZLB are buttressed by analysis of the longer-term outlook for interest rates. In the mid-2000s, we estimated the real neutral rate of interest to be in the 2 1/2 to 3 1/2 per cent range. Today, we think it is more likely in the 1 to 2 per cent range (or 3 to 4 per cent in nominal terms). 6 All else being equal, a lower neutral rate implies a greater probability of being constrained by the ZLB. Preliminary evidence for Canada suggests that with an unchanged inflation target, the probability increases from about 5 per cent to about 15 per cent. This is not trivial. On the other hand, there are factors that will work in the opposite direction, reducing the likelihood of ZLB episodes. The most important is global financial regulatory reform, which is expected to reduce the likelihood of financial crises – a common cause of shocks large enough to necessitate near-zero interest rates. 7, 8 While a number of prominent economists have argued for a higher inflation target, there is good reason to be cautious. 9 The credibility of the 2 per cent target is invaluable. It accrued gradually over time as 2 per cent came to be perceived as a stable and achievable objective. Changing the target could cause it to become regarded as temporary in nature. A lesscredible target would limit the flexibility and effectiveness of monetary policy as a stabilization tool. Our research will undertake a careful analysis of the costs and benefits of adjusting the target. See E. Santor and L. Suchanek, “Unconventional Monetary Policies: Evolving Practices, Their Effects and Potential Costs,” Bank of Canada Review (Spring 2013): 1–14. We define the neutral rate as the policy rate that will prevail after the effects of all cyclical shocks have dissipated. The estimated decline in the neutral rate mainly reflects lower potential growth rates and higher global savings. See C. Wilkins, “Monetary Policy and the Underwhelming Recovery” (speech to the CFA Society Toronto, Toronto, Ontario, 22 September 2014); and R. Mendes, “The Neutral Rate of Interest in Canada,” Bank of Canada Discussion Paper No. 2014–5, September 2014. For example, a study conducted by the Financial Stability Board and the Basel Committee on Banking Supervision, with the participation of Bank of Canada staff, found that an increase of 2 percentage points in bank capital ratios reduced the probability of a financial crisis from 4.5 per cent to 1.6 per cent. We also need to consider the possibility of reduced measurement bias in the CPI, given improvements made by Statistics Canada in the past few years. A lower bias would lead to a higher true rate of inflation for a given inflation target, thus mitigating the need for a higher target. See P. Krugman, “Inflation Targets Reconsidered,” ECB Sintra Conference, May 2014; and L. Ball, “A Case for a Long-Run Inflation Target of Four Percent,” IMF Working Paper 14/92, June 2014. For an earlier appeal to central banks to at least consider a higher target, see O. Blanchard, G. Dell’Ariccia and P. Mauro, “Rethinking Macroeconomic Policy,” IMF Staff Position Note, 12 February 2010. BIS central bankers’ speeches The integration of financial stability considerations – a work in progress The Bank concluded in 2011 that monetary policy should be the last line of defence against financial imbalances. This has since become the dominant view in the central bank community. Nonetheless, after years of aggressive monetary stimulus in major advanced economies, concerns about the buildup of financial stability risks have increased, leading some to question whether the appropriate trade-offs are being made between price stability and financial stability. Indeed, some critics have argued that the current monetary stimulus is simply sowing the seeds of the next financial crisis. However, as Governor Poloz discussed in a recent speech, the alternative is not attractive. 10 Here in Canada, financial stability risks – mainly household imbalances – have been on our radar. To address these imbalances, a number of regulatory changes were made, which have contributed to a more constructive evolution, although the risks have been edging higher. 11 Financial stability risks have also been taken into account as part of our risk-management approach to monetary policy. 12 When the flexibility inherent in getting inflation back to target within a reasonable time frame permits, the Bank has opted for tactics that do not exacerbate financial stability concerns. The Bank adopted a tightening bias from April 2012 to October 2013, noting that the evolution of risks related to household imbalances may be a factor affecting the timing and degree of withdrawal of monetary stimulus. Thus far, however, the Bank has not had to use its monetary policy instrument to lean against financial risks. Going forward, additional research will be helpful to specify more fully the circumstances under which it would be appropriate for the Bank to use monetary policy for financial stability purposes. Recent work at the Bank suggests that the best outcome is achieved when macroprudential policy targets emerging imbalances in the economy, such as excessive growth in credit, leaving monetary policy free to focus on price stability. 13 Of course, these polices must take account of one another. Thus, for example, tighter macroprudential policy would require a more stimulative monetary policy, other things being equal, and vice versa. How to best integrate price stability and financial stability remains a work in progress. Implementation of the global financial reform agenda both here and abroad should increase the resilience of our financial system and reduce the need for monetary policy to react. Still, much remains to be learned about the effectiveness of macroprudential instruments and the optimal mix of policy tools. Communication challenges associated with potentially moving macroprudential and monetary policies in opposite directions should also be examined. The measurement of core inflation – should CPIX continue to beour main guide? As much as we aim for low, stable and predictable inflation, there will always be sharp movements in CPI inflation. These are generally driven by volatile price changes in a small number of goods and services that often tend to reverse quickly. Such price changes add considerable “noise” to total CPI, making it difficult to discern genuine movements in trend S. Poloz, “The Legacy of the Financial Crisis: What We Know, and What We Don’t” (speech to the Canadian Council for Public-Private Partnerships, Toronto, Ontario, 3 November 2014). The Minister of Finance has tightened mortgage insurance rules, the Superintendent of Financial Institutions has developed stronger mortgage underwriting principles, and the Canada Mortgage and Housing Corporation has restructured its programs. S. Poloz, “Monetary Policy as Risk Management” (speech to the Canadian Club of Montreal, Montréal, Quebec, 12 December 2013). See also S. Poloz, “Integrating Uncertainty and Monetary Policy-Making: A Practitioner’s Perspective,” Bank of Canada Discussion Paper No. 2014–6, October 2014. S. Alpanda, G. Cateau and C. Meh, “A Policy Model to Analyze Macroprudential Regulations and Monetary Policy,” BIS Working Paper 461, September 2014. BIS central bankers’ speeches 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. An effective core measure must have four key properties. It must be less volatile than total inflation; track long-run movements in the total CPI very closely (in other words, be “unbiased”); reliably predict future trend movements in the total CPI; and be easy to understand and explain to the public. The Bank calculates and publishes several core measures that meet these criteria to varying degrees. Within this set, CPIX has been our main guide since 2001. 14 Although CPIX isn’t a perfect measure of underlying inflation, it has a number of advantages. It depicts relatively low volatility and is fairly straightforward to calculate. 15 However, excluding some of the most volatile components from the CPI doesn’t guarantee that the resulting measure will always be smooth. Some components included in CPIX (for instance, electricity) have shown fairly high volatility in recent years, while others, such as the prices of autos and certain regulated services, have tended to move countercyclically, thereby obscuring the relationship between CPIX and the output gap. 16 Alternative measures of core inflation provide additional valuable information in this context. For instance, the Bank’s common component is well suited to seeing through one-off isolated price changes and tends to be more highly correlated with measures of economic slack. 17 But it isn’t perfect either. It can be hard to explain, given its reliance on more advanced statistical methods. Against this background, the properties of various measures of core inflation will be reexamined to determine whether the Bank should continue the practice of identifying one preeminent measure of inflation as its operational guide and, if so, whether CPIX should continue to play that role. Conclusion Let me conclude. Canada’s inflation-targeting framework merits top marks. It has performed extremely well in good times and helped us weather the bad times. For this reason, any modification to the framework must be thoughtfully researched and carefully considered. This doesn’t mean there is no room for improvement, just that – as I emphasized earlier – the bar for change is high. By anchoring inflation expectations, the policy has earned invaluable credibility. It would be a mistake to compromise that credibility. Although the financial crisis and its aftermath are forcing all central banks to reassess their operating frameworks and mandates, conducting such reviews is a well-established routine for us at the Bank of Canada. We believe that one of the core strengths of our policy framework is the research program we undertake leading to the periodic renewals of the agreement with the Government of Canada. Research on the issues I have raised in this speech will help to inform the next renewal and, more broadly, the conduct of monetary policy. CPIX excludes eight of the most volatile components of the consumer price index and adjusts the remainder for the effect of changes in indirect taxes. The components are fruit, vegetables, gasoline, fuel oil, natural gas, intercity transportation, tobacco and mortgage-interest costs. T. Laflèche and J. Armour, “Evaluating Measures of Core Inflation,” Bank of Canada Review (Summer 2006): 19–29. See Box 2, Monetary Policy Report, April 2014. The common component uses a factor model to extract the component of inflation that is common across the individual series that make up the CPI. See M. Khan, L. Morel and P. Sabourin, “The Common Component of CPI: An Alternative Measure of Underlying Inflation for Canada,” Bank of Canada Working Paper No. 2013–35, October 2013. BIS central bankers’ speeches Transparency is important to us. We will keep the public informed about the progress of our work over the next two years. We are assembling on our website material related to the framework and research we are undertaking in the run-up to the 2016 renewal. 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 low, stable and predictable inflation. This will not be sacrificed. The only question, as always, is whether it can be delivered in an even more effective and reliable manner. Thank you. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Financial System Review, Ottawa, Ontario, 10 December 2014.
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Stephen S Poloz: Release of the Financial System Review Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Financial System Review, Ottawa, Ontario, 10 December 2014. * * * Good morning. Senior Deputy Governor Carolyn Wilkins and I are pleased to be here today to discuss the December issue of our biannual Financial System Review (FSR), which we published this morning. The purpose of the FSR is not to predict the most likely outcomes for the financial system. Instead, we use it to highlight key financial vulnerabilities and the catalysts that could turn those vulnerabilities into a risk to the financial system. The FSR is an essential complement to our Monetary Policy Report. Together, the two streams of analysis provide the basis for a fulsome discussion of monetary policy, within a risk-management framework. Although we view risks to the financial system separately from risks to growth and inflation, we think carefully about the interplay between them. In this FSR, we discuss three important financial system vulnerabilities: high household indebtedness; imbalances in the housing market; and increased investor risk taking. To some extent, all three are normal side effects of stimulative monetary policy. However, the post-crisis recovery has been frustratingly slow – we have called it serial disappointment – and bond yields and policy interest rates have been unusually low for a long time. In this context, these financial vulnerabilities have built up over time. Fortunately, Canada’s economy is showing the first signs of a broadening recovery. Nonenergy exports have been responding to stronger U.S. growth and exchange rate depreciation, investment spending appears to be picking up, and we have seen pockets of new job creation. This natural rebuilding sequence is key to reducing financial vulnerabilities over time. In particular, our expectation of a soft landing for housing hinges on stronger growth, employment and incomes. The recent weakness in oil and other commodity prices raises important risks to this economic outlook, however. This shock is especially complex: it is likely to boost global growth but to moderate growth and inflation in Canada, even though the effects should be tempered by exchange rate depreciation and stronger non-energy exports. The potential consequences for the financial system will be monitored carefully in the months ahead. Meanwhile, the global financial system is stronger and more resilient, thanks to continued progress on implementing the G-20 regulatory framework and the efforts of policy-makers and market participants around the world, including Canada. In light of this continued progress, and taking into account the early signs of stronger exports, investment and employment in Canada, we judge that the probability of an adverse shock has eased since our June FSR. This mitigates our observation that some financial vulnerabilities appear to be edging higher, leaving our overall assessment of financial stability risk roughly the same as in June. That is why we continue to believe that the overall balance of risks remains within the zone for which the current stance of monetary policy is appropriate. Let me just add a few comments specific to the most important risk discussed in the FSR: the difficulty that highly indebted households would have servicing their debt if they were to face a sharp decline in their incomes or a sharp rise in interest rates. This situation raises the risk that a shock to the economy could trigger a correction in house prices. The probability of this risk materializing is low, but if it did occur, the effect on the economy would be severe. BIS central bankers’ speeches This risk would be greater if house prices were judged to be overvalued relative to fundamentals. Bank economists have done some new research on this risk, highlighted in a box in our FSR, and in a research paper released today on our website. Although there is considerable uncertainty around this question, various approaches – including our own – suggest that there is some risk that the housing market is overvalued, and our estimates fall in the 10 to 30 per cent range. We experienced housing corrections in the early 1980s and the early 1990s, after periods when prices became overvalued to a similar extent. But both of those episodes were preceded by a much faster run-up in prices amid rising inflation expectations. In both cases, interest rates rose as monetary policy leaned against inflation, and a recession ensued. None of those conditions is present today. The rise in house prices has been much more gradual and, in the context of a broadening recovery, the unwinding of household imbalances should be gradual as well. That is why we continue to expect a soft landing in the housing market, but it is conditional on continued strengthening in the economy. Let me reiterate the bottom line of the Financial System Review: After careful analysis of the latest economic, financial and regulatory developments at home and abroad, our assessment is that while vulnerabilities associated with household indebtedness and housing markets are edging higher, the overall risk to financial stability in Canada is roughly the same as it was at the time of our June FSR. With that, Carolyn and I are happy to take your questions. BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Economic Club of New York, New York City, 11 December 2014.
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Stephen S Poloz: Speculating on the future of finance Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Economic Club of New York, New York City, 11 December 2014. * * * Introduction Thank you for the invitation to speak here today. It is always a pleasure to be in New York, and it is a special treat for me to address this distinguished audience. I’d like to talk with you about the future of finance. Now, I know I don’t have to convince anyone in this room of the importance of financial intermediation. Just as you can’t have lights without power lines, you can’t have economic growth without financial intermediation. But as you also know well, our financial regulators have spent the last five years putting financial reforms in place in the wake of the 2008 financial crisis. There is absolutely no doubt that these reforms will affect the future of finance, but none of us really knows how. Financial intermediation is already evolving in response to the reforms, and I think it is worth speculating on how these trends might develop in the future. The only assumption I make is this one: no amount of regulation can snuff out the forces of competition – competition is a force of nature, and it is going to manifest itself in some way, for there is a lot of money at stake. Regulatory response to the crisis: too much or too little? At the G-20 Summit in Brisbane, leaders acknowledged that we have delivered on the core commitments made in response to the financial crisis. Yes, there are still some important issues to address, particularly with respect to consistent implementation of these reforms. But for the most part the core of the world’s financial system is far safer today. Depending on your perspective, these reforms are either overly harsh, or too lax. A systemically important bank sees the steep cost of reform, while the unemployed worker still feels the steep cost of the crisis. My perspective as a central banker is a macro one, and I can tell you that by the end of last year, the cumulative loss to global output owing to the crisis was roughly US$10 trillion, which is close to 15 per cent of global GDP. Over 60 million jobs were destroyed. We have rightly made a strong commitment to address the most serious fault lines exposed by the crisis, to reduce significantly the probability and severity of future ones. In short, we would like to ensure that this never happens again. No doubt, the sweeping scope and complexity of these reforms has some thinking that the new regulatory architecture is excessively tight, at least at first glance. Of course, optimizing the scope and intensity of regulation was never going to be easy. The new regulatory architecture is the outcome of a political process with many trade-offs and significant differences across financial systems. Accordingly, the principles behind the reforms matter more than the rules themselves – principles, complemented by a high level of supervisory vigilance. Fact is, the financial world is a dynamic place, where competition is inherent to it, regardless of market structure. Principles-based financial regulation sets a high bar under which competitive forces can still foster financial innovation, innovation that is more likely to be socially improving than simply evasive. BIS central bankers’ speeches In Canada, active and vigilant supervision goes hand in hand with this principles-based approach to regulation. To help monitor potential emerging risks, we have a comprehensive radar system that includes surveillance, guidance and enforcement. Canadians have found that this complementary approach to regulation and supervision is conducive to responsible financial innovation. An important objective of these G-20 financial reforms is consistent implementation across jurisdictions, but in a manner that avoids unduly impeding financial innovation. I see such innovation in financial intermediation as essential to fostering regulatory balance between maintaining financial stability on the one hand and facilitating competitive market forces on the other hand. As people in the financial industry create new ways to do business – some call this regulatory arbitrage, which of course sounds like a bad thing – their innovations help re-set this balance, prompting regulation to adapt to positive progress in financial intermediation. There is a natural incentive behind financial innovation, since there is a lot of money at stake for those who innovate successfully. There is a lot at stake for the macroeconomy, too, because a return to sustainable economic growth around the world will require continued financial innovation. Regulation must allow these natural forces to manifest themselves, albeit in a safe way. Where the creative forces might take us Given this context, let’s speculate about the future of financial intermediation: How will the forces of competition manifest themselves in the years ahead? Let’s start with banks. Some may choose to shed business lines that have relatively low riskadjusted returns. In particular, capital market activities could shrink as the risk weights associated with them increase. This has already started: since 2007 global banks have already sold off more than US$700 billion in assets and operations, of which foreign operations account for almost half. Furthermore, in response to the new resolution requirements, some large banks may simplify their organizational structures. I’m not suggesting that large universal banks will disappear. They will likely persist, at least because of the significant economies of scale associated with payments and foreign exchange. Large banks will also remain because there will be an ongoing need to serve global clients. For their part, smaller and less-complex banks will probably increase their focus on traditional banking. We can’t be definitive about these predictions, for we simply do not know how competitive forces will operate in this new environment. But it would be surprising if the net effect were not to reduce the availability of credit. If financial markets had imperfections before, some of those imperfections are likely to be even more evident under the new regulatory environment. This is straight out of your first economics textbook. It goes without saying that reduced availability of credit would be a headwind to economic growth. And, if there are funding gaps in our system at the best of times, and they turn out to be a little bigger under our new regulatory umbrella, those funding gaps will probably be found in all the usual places: lending for young businesses, small- and medium-sized companies, trade finance and infrastructure, to name a few. These areas of retreat by banks could look like good opportunities for other financial intermediaries. We can imagine several different channels where the forces of competition might emerge, all of which could occur simultaneously. BIS central bankers’ speeches First, there is market-based finance. As banks rein in their risk-taking, we can expect that market-based finance will play a larger role than it currently does. We can see this happening already. For starters, in some markets companies increasingly fund themselves by issuing bonds on the market. In the U.S., while bank dealers have significantly reduced their inventories of corporate bonds, non-bank lenders have increased their holdings of corporate bonds. Whether they are structured as asset managers, insurers, non-bank financial firms or retail investors, these groups are opportunistically filling the void that traditional bankers have created. Securitization is another market-based channel that could really expand in this new world. Although the very word securitization has been tainted by the crisis, I can imagine that a new class of high-quality, low-risk securitization products could differentiate itself from the mistakes of the past. Such innovations are to be welcomed, provided that they are created in a manner that does not pose new or growing risks to the financial system, such as liquidity shortfalls in times of stress. Importantly, market-based finance can even be a source of economic stability, if such intermediaries react differently to market turbulence than banks. In effect, countries with diversified financing sources may be better placed to weather shocks to the economy. However, market-based finance is unlikely to erase all of the imperfections in our future financial system. In particular, market-based finance is not very effective in reducing information asymmetries, so it probably will not fill the funding gap for young, small- or medium-sized businesses. No doubt, Mother Nature has a plan to fill those gaps in time, and one probable source is private lending and equity, a second channel where competitive forces are likely to emerge. There have been significant advances in technology that are sure to influence the future provisioning of private capital. One notable example is peer-to-peer (P2P) finance, which directly connects private lenders with borrowers via the Internet. An important element of this model is that there is no middleman, nor is there any liquidity or maturity transformation as in traditional banking or market-based finance. While P2P finance is still in its infancy, it is already transforming private capital provision and growing fast in pockets in the U.K., the U.S. and China. Although it originally focused on pooled funds from smaller investors, P2P finance is increasingly being dominated by big institutions and hedge funds with about two-thirds of the funds loaned coming from institutional investors. This is already changing the face of P2P finance in very important ways. P2P finance has an impressive cost advantage over traditional banking and since there is a lot of money at stake, as usual, competitive forces are certain to manifest themselves. With automated credit checks and “no skin in the game,” the operating expenses in P2P lending, for example, run about one-third that of traditional banks. With that advantage, P2P lending provides the opportunity for both savers and borrowers to get a “better” deal. However, there is no such thing as a free lunch. The cost of that better deal is the significant risk that the participants take on. Despite the risks, we can easily imagine a world in which P2P finance thrives. It has already begun to spread to a wide variety of new sectors, such as student loans, real estate, hedging, auto loans, equipment finance, medical loans, business-to-business lending, and so on. Over time, we could see P2P finance become more global, and could also see the development of a deep secondary market in securitized P2P loans. If I am right that there will be less credit available from traditional banks, it’s not a stretch to think that the young, the small and the medium, and the risky companies, will begin to tap into this P2P finance channel to meet their credit needs. BIS central bankers’ speeches This evolution could be key to an eventual return to sustainable economic growth, as I am convinced that a return to natural growth – as opposed to policy-induced growth – will require a resumption of new firm creation, sustained by innovative financial intermediation. Will a surge in P2P finance mean new risks to the financial system? Perhaps. Will those risks be systemic in nature? We don’t have a clear answer yet, but with the increasing participation of institutional investors in this space and increasing market shares of P2P finance, there could be financial stability implications. And what if Mother Nature does not fix all the imperfections in our financial system through market-based or private finance? The third channel that we might expect to play an enhanced role in a credit-constrained world is public finance. Public financial intermediaries are active in such areas as lending to small and medium-sized enterprises and trade finance, and these demands could rise in the years ahead. But the bigger need for a public sector solution is more likely to be in the area of infrastructure investment. So-called “green infrastructure” is particularly susceptible to market failure, as it suffers from both the basic free-rider problem and societal mispricing – a double market failure, if you will. Public-private partnerships (or P3s) have proven to be an increasingly effective tool for funding these investments, but they have not been a panacea. The P3 space is not exempt from our call for more financial innovation. Innovative ways of risk-sharing in investment projects – for example, governments offering innovative guarantee structures where they take on a contingent fiscal risk as opposed to laying out large expenditures up front – are clearly worth experimenting with. Private sector intermediaries, pension funds, and sovereign wealth funds should be actively encouraged to develop and propose such innovations. Once again, there is a lot of money at stake. It should be clear by now that I am a big fan of market forces. The returns from successful financial innovation in market-based finance and P2P finance are likely to be very large, from the perspectives of both the innovator and the macroeconomist. Allowing those competitive forces to flourish, within principles-based regulation aimed at protecting the financial system, is essential for future economic growth. Tweaking public financial intermediation should take care of the rest of our market imperfections. But all of these market structures exist already, so speculating on their future is not that much of a stretch. That makes me wonder if we are missing something big. How blue-sky do we want to get? Does anybody besides me wonder what the banking system looks like in the background of Star Trek? Or, what about the corporatist model of finance, which lies in the background of Margaret Atwood’s novel, The Year of the Flood? Now that’s blue-sky thinking: people work for a massive corporation, live in the corporate compound, go to corporate restaurants and events, and bank with a financial intermediary wholly-owned by their own employer, which in turn invests the funds in growth for the corporation. I suppose that model is far-fetched, but I present it as an illustration that the sky really is the limit in this space. I have offered you a range of possibilities today, but there are many other possible futures for finance. Financial stability is a shared responsibility A bright future is one where the financial system is safe and efficient – and innovative. Financial regulation needs to be designed to allow competitive forces to work, and allow innovation to happen. BIS central bankers’ speeches I said earlier that it is very difficult to strike the perfect balance between regulation and innovation. Indeed, public authorities can’t strike a perfect balance alone. That balance is the product of regulation and the underlying forces of competition I have talked about. The simple fact is that financial intermediation is, for the most part, a scale business. Operating at scale creates the risk of market failure, or market imperfections, as we well know. Accordingly, operating at scale demands that the financial intermediary do so under a social license which, of course, goes hand in hand with regulation. In short, this is a contract. All contracts function best when the two parties live not just by the letter, but by the spirit underlying the agreement. I’ve asked you to imagine some possible financial futures; now, can you imagine one where regulated financial players uphold not just the letter, but the spirit of the new global regulatory framework? What I am suggesting is that the industry be at the vanguard of positive change, and voluntarily embrace the spirit of financial regulation. Use this positive response as a brand to rebuild trust in the street, especially Main Street. And, in the process, demonstrate the effectiveness of principles-based financial regulation that allows competition and innovation to facilitate economic growth. Conclusion Let me wrap up. Financial regulation is costly, but that cost pales compared with the fallout from the financial crisis. We are still paying for that. Global regulatory reform was absolutely essential. So let’s work together to make it better. Thankfully, the balance between regulation and innovation is dynamic, not static – competitive forces ensure this. We are at a critical juncture for the global economy. We have been through a destructive business cycle, and policies will need to remain stimulative until the legacy headwinds subside and the rebuilding phase truly gets underway. That rebuilding phase will require a substantial pickup in new firm creation and young firm survival, in particular, which will foster new job creation. Creative financial intermediation is a necessary ingredient for this rebuilding process. In Canada, we had a less difficult cycle than most other countries, in part because of the resilience of our financial system. Even so, we saw significant destruction in our export sector, the backbone of our economy. We have been waiting for a resumption of export growth, to be followed by a rekindling of animal spirits, investment in new capacity and new firm and new job creation, and it looks like that natural sequence may have finally begun. We have plenty of room to grow, however, so it will take another couple of years before our economy can enjoy steady, natural growth with inflation sustainably on target. It is this return to natural growth that we all want to see. But it simply will not happen without vigorous and innovative financial intermediation. We need to embrace our new regulatory architecture and get on with the job. BIS central bankers’ speeches
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Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the International Trade Association (MITA), Madison, Wisconsin, 13 January 2015.
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Timothy Lane: Drilling down – understanding oil prices and their economic impact Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the International Trade Association (MITA), Madison, Wisconsin, 13 January 2015. * * * The charts can be found at the Bank of Canada’s website. Introduction Good afternoon. I want to thank the Madison International Trade Association for inviting me to this annual outlook event. I’m happy to be back in America’s Midwest, a region that has many important ties to Canada. Your economy has a lot in common with ours, and it is affected by many of the same global forces. The dramatic drop in oil prices over the past few months is certainly a major new force in the world economy today (Chart 1). Oil prices affect almost everyone, for better or for worse. Petroleum products are a big slice of families’ budgets and a significant cost of production for a myriad of industries. Oil is especially important to both of our countries. In Canada, oil extraction now accounts for about 3 per cent of our GDP and crude oil about 14 per cent of our exports. The United States is still the world’s largest consumer of oil and, with the emergence of shale-oil production, has become the biggest producer too. Oil is also at the heart of Canada-U.S. economic relations. The United States is the market for close to 100 per cent of Canada’s oil exports. Our oil exports to the United States have been growing strongly, even as the United States has been reducing its overall reliance on imported oil. As a result, Canadian oil makes up about 40 per cent of U.S. crude oil imports, and that share is expected to grow over the years ahead (Chart 2). This trade is evident here in Wisconsin; one example is the terminal of the Alberta Clipper pipeline in Superior and the cluster of industries surrounding it. As I will discuss, the rapid expansion of oil production in both of our countries has been a real game-changer in the global oil industry. World oil markets have been turbulent over the past several months. In the next few minutes, I will describe the fundamental economic forces that are at play. I will also highlight the uncertainties surrounding both those forces and the other factors affecting oil prices. I will then discuss how lower oil prices affect the global, U.S. and Canadian economies – who wins and who loses? The commodities super-cycle Over the past decade and a half, world oil prices, and commodity prices in general, experienced a sustained upward movement, often called the “super-cycle” (Chart 3). By far the most important reason for this long-term trend is the rising demand for these products stemming from rapid economic growth in China and other emerging-market economies. 1 Researchers Kilian and Lee estimate that demand shocks accounted for about 60 per cent of the increase in oil prices during the run-up from US$30 a barrel to US$140 a barrel. See L. Kilian and T.K. Lee, “Quantifying the speculative component in the real price of oil: The role of global oil inventories,” Journal of International Money and Finance, 42 (April 2014): 71‒87. BIS central bankers’ speeches It would be hard to exaggerate the importance of the integration of China, India and other emerging economies into the world economy. The economy of China alone doubled in size between 2007 and 2013, an expansion built on the production of goods requiring energy to manufacture. With rising living standards, Chinese households have been able to afford cars and other products that consume energy. China’s oil consumption followed suit, doubling over the past decade to about 10 million barrels a day and making the country the world’s second-largest consumer of crude oil. This growing demand for energy put continued upward pressure on oil prices. Over time, the industry responded by stepping up exploration, developing higher-cost sources, and making some major technological breakthroughs. With the recent drop in oil prices, some commentators have been quick to declare that the super-cycle is finished, but these underlying forces still have a long way to run (Chart 4). The urbanization and industrialization of emerging economies and the growth of their middle classes is far from complete. China’s urban population has grown by about 300 million people since 2000 but, even now, only 55 per cent of its people live in urban areas, compared with more than 80 per cent for North America and advanced Asian economies such as Japan and Korea. According to some estimates, another half-billion people in China and India alone will move to cities and likely join a growing middle class over the next two decades. As long as these trends continue, they will add to world demand for oil. The disappointing global cconomy Although the forces underlying the commodities super-cycle are still at work, demand for oil is likely to expand on a slower track than in the past. 2 Global economic growth has repeatedly fallen short of expectations in the aftermath of the financial crisis of 2007–08 (Chart 5). That disappointing pattern, in turn, reflects two sets of factors. First, the fallout from the global financial crisis turned out to be much more prolonged and severe than most economists expected. Even now – seven years later – there are important headwinds to global economic growth. Public and private indebtedness at a global level is at a historic high, and there is also the lingering uncertainty resulting from the bitter experience of the past few years (Chart 6). Still, global economic growth is picking up as progress is being made on deleveraging and as confidence improves. The most recent Bank of Canada projections show a global growth rate of 3 1/2 per cent this year and next, compared with 3 per cent last year. The recovery is particularly robust in the United States, where the policy response to the financial crisis was more timely, aggressive and sustained than in other major advanced economies. Second, certain important structural factors suggest that, over the longer term, world economic growth will be slower than in the past. One important reason is demographics: aging populations in advanced and some emerging economies. Another is the maturing growth of emerging economies such as China: it is probably impossible for China to sustain economic growth at the double-digit rates of the 2000s – although its growth rate is still expected to stabilize at an enviable annual pace of 7 per cent for the foreseeable future. Both sets of factors suggest lower global economic growth than before the crisis. Disappointing global growth, and the resulting slower growth of energy demand, are a significant part of the background to the recent movement in oil prices. But, in our view, increased supply probably played an even greater role. For example, since July 2014, the International Energy Agency has revised down its estimates for 2014 global oil demand by 0.3 million barrels a day and 2015 demand by 0.8 million barrels a day. BIS central bankers’ speeches The Hog cycle It’s only a slight exaggeration to say that, when oil is worth $100 per barrel, there is oil everywhere. The U.S. oil industry is a case in point (Chart 7). The so-called “shale revolution” that started six years ago has been nothing short of astounding. In 2008, the production of shale oil was almost non-existent. Today, the sector produces about 4 million barrels a day and, before the recent drop in prices, was on track to increase its output to almost 4.8 million barrels a day in 2020. We’ve also seen a powerful supply response to high prices in Canada. Oil sands production rose fivefold between 1993 and 2014, to 2.3 million barrels per day, and now accounts for more than 60 per cent of Canada’s crude production. Between 2006 and 2013, investment in the oil sands more than doubled to over $30 billion (Chart 8). Two distinguishing features of unconventional oil affect the dynamics of the market. First, the extraction cost of most of the new oil is relatively high. A barrel of shale oil costs between $40 and $80 to extract, depending on the project; oil from Canada’s oil sands costs closer to $60 to $100 a barrel (Chart 9). In many cases, this is mainly a reflection of the upfront cost of investment and exploration, rather than the continuing cost of keeping oil flowing from existing installations. Of course, these costs may also vary over time with changing technology and competitive forces. Second, it takes time and, in some cases, major investments, to bring a new supply of oil on stream. When demand increased over the past several years, supply could not be expanded right away. Instead, prices shot up, creating incentives to explore, innovate with extractive technology and invest in new facilities. Over time, these activities have delivered an outsized supply response, which has been driving prices down. So what happens next? When the price drops below the all-in cost of production, and is expected to stay there, that discourages further exploration and investment. Indeed, in recent weeks, a number of oil companies have announced that they are scaling back investment. This is important, since new investment is needed to offset naturally occurring declines in production in existing fields. But before existing production is actually taken off stream, the price would have to drop a lot further – below the short-run marginal cost (sometimes referred to as the “cash cost”) (Chart 10). Except for some smaller companies that may cut output more quickly as their access to financing is restricted, producers are likely to take time to adjust, especially if they have hedged against price movements. In all, it may take quite some time before supply and demand are brought back into balance – although technological change may enable some suppliers to adjust their production more quickly than in the past. It should not be surprising, then, if oil prices overshoot their trend in one direction or the other. Cycles like this are typical of markets where both supply and demand are inelastic in the short run, and where it takes time for the long-run supply response to materialize. Indeed, the basic forces at work are the same as in the hog cycle – a cycle that economists learned to analyze about 80 years ago. 3 When hog prices are high, producers rush to increase their herds. As the pigs reach maturity, producers bring their increased supply to the market all at the same time, causing a glut. Prices fall, and producers cut back their production. This leads to a shortage. Prices start rising, and the cycle starts anew. What does this tell us about where oil prices are likely to end up and how low they can go in the meantime? N. Kaldor, “A Classificatory Note on the Determinateness of Equilibrium,” The Review of Economic Studies 1, no. 2 (February 1934): 122‒36. BIS central bankers’ speeches First, with current expectations for global economic growth, the demand for oil will continue to rise – and the world is likely to require some higher-cost oil to satisfy that demand. Barring major changes to technology or a large shock to the global outlook, today’s oil prices are unlikely to be high enough to balance supply and demand. This is consistent with what both the futures curve and our own model of oil prices are telling us. 4 Of course, there is considerable uncertainty around the equilibrium level – both because all the risks to global growth translate into risk to oil demand and because new technology is bringing costs down all the time (Chart 11). Second, prices can be subject to large overshoots in the short run, in either direction. The only true floor to prices in the short term is the short-run marginal cost, at which point producers would lose more money by continuing to pump oil from existing installations than by shutting it in. OPEC, geopolitics and financialization So far, I’ve been focusing on the fundamentals of supply and demand, which, in my view, go a long way toward explaining the recent plunge in prices. But in the short run, there are a number of other important influences that are more difficult to predict. I would like to say a few words about three other pieces of the story. First, geopolitical developments often have a major impact on oil prices – since they can affect oil supply directly and since the threat of future supply disruptions can also build a risk premium into oil prices. As a notable example, in the early part of 2014, conflicts in Libya and Iraq led to temporary outages in their oil production, keeping world prices high, even as supply elsewhere in the world continued to ramp up. When production from those two countries came back on stream, that was an important trigger for the plunge in oil prices later in the year. Of course, such conflict situations and other geopolitical events can change very quickly in one direction or the other, and continue to pose an important source of risk. Second, the Organization of the Petroleum Exporting Countries (OPEC) has had an important influence on the dynamics of world oil markets, and this influence may be changing over time. The drop in oil prices was accelerated in early December by OPEC’s decision to leave its production target unchanged, even as prices were falling. In effect, OPEC members were allowing the price to fluctuate so that more supply adjustment would come from other producers, rather than acting as the “swing producers” as they had in some other episodes. This changing role may reflect, in part, the decline in OPEC’s share of world production – which, at about 40 per cent, is 10 percentage points lower than in its heyday (Chart 12). It is too early to tell whether and how OPEC’s behaviour will change as its market share continues to decline. Third, financial linkages. With the run-up in commodity prices during the past couple of decades, much attention was paid to the “financialization” of commodities – including investor flows into commodity-based mutual funds and exchange-traded funds, increased involvement by global investment banks in commodity-backed lending and physical commodity trading, and the prominent role of large commodity-trading houses. 5 Financialization has gone into reverse in recent years, owing to a combination of moderating trends in commodity prices and regulatory changes. The research we have done at the Bank C. Baumeister, “The Art and Science of Forecasting the Real Price of Oil,” Bank of Canada Review (Spring 2014): 21–31. T. Lane, “Financing Commodities Markets,” (speech to the CFA Society of Calgary, Calgary, Alberta, 25 September 2012). BIS central bankers’ speeches of Canada on the role of investment flows in commodities markets shows that these flows may amplify or accelerate price movements, but do not create trends on their own. 6 There is still a question of whether financial flows may have accelerated some of the price movements that we have seen – for instance, if investors who had been drawn to the oil market by rising prices faced margin calls and decided to pull out after suffering losses. At this point, data on speculative positioning in oil markets do not suggest that such effects were driving recent market movements, but we cannot rule out that they may have been either a contributing or a mitigating factor. Moreover, we remain alert to the possibility that financial linkages could transmit stress from oil markets to the financial system. Putting all the pieces together, we conclude that there are two-sided risks around current oil prices: sizable short-run movements in either direction are quite possible. Despite some promising research at the Bank of Canada on forecasting oil prices, the range of uncertainty around even the best forecasts is very wide. 7 In view of this uncertainty, the Bank’s baseline economic projections are constructed on the assumption that oil prices remain constant over the projection period. 8 We use information from our models and other sources to understand and highlight the risks around that baseline. Global economic impact What will the drop in oil prices mean for the world economy? We are still finalizing our complete forecast of the global and Canadian economies, which the Bank of Canada will release next week in our Monetary Policy Report, but here is how we approach the question. For the world as a whole, the decline in oil prices is beneficial. If it is caused by new sources of supply, the price drop spreads the benefits of a favourable shock; if it is partly the result of slower demand growth, it mitigates the effects of an unfavourable shock. It is no surprise that lower oil prices benefit consumers and hurt producers. For the users of oil, a lower price is like a tax cut. The positive effect will work its way through the economy via two channels: first, it will give consumers more disposable income, which they can spend on goods and services; second, it will reduce input costs and encourage production in sectors other than oil, especially energy-intensive sectors. The United States, as a net importer, will benefit from the drop in oil prices. Our October forecasts were for U.S. growth to average around 3 per cent over the next couple of years, and the positive oil shock adds an upside risk to our projection. Other economies that are large net importers of oil, such as China, Japan and Europe, will also get a boost to their economic growth. The decline in oil prices has clear adverse effects, however, on oil-exporting emerging economies. Some of these countries, which have relied on high oil prices to balance their budgets, could face financial stress (Chart 13). While lower oil prices will undoubtedly depress headline inflation, this is a temporary effect that central banks will look through in setting monetary policy. Provided that consumers and businesses understand that the drop in oil prices is a one-time change, it should not slow the pace of underlying inflation. R. Alquist and O. Gervais, “The Role of Financial Speculation in Driving the Price of Crude Oil,” Bank of Canada Discussion Paper No. 2011–6, 2011. C. Baumeister, “The Art and Science of Forecasting the Real Price of Oil,” Bank of Canada Review (Spring 2014): 21–31. This work also shows that a no-change assumption is more accurate than one based on the futures curve. Bank of Canada, Monetary Policy Report, April 2014. BIS central bankers’ speeches In Europe and Japan, which have been grappling with slow economic growth and low underlying rates of inflation, the situation could be more problematic. There is a risk that lower oil prices could add to deflationary pressures or even trigger a generalized downward price spiral, but that is not our base case. Implications for Canada Canada, like other countries, has been trying to regain its economic footing since the global financial crisis. From the outset of the Great Recession, the Bank of Canada has been providing significant monetary stimulus. But we have yet to reach the point where growth is self-sustaining. For that to happen, the sources of growth will have to rotate away from consumption and toward increased exports, which are our traditional economic engine. Signs of a broadening recovery have been emerging during the past year. Stronger U.S. growth and a weaker Canadian dollar have boosted non-energy exports. Investment spending and job creation have also begun to pick up, although significant slack remains in the labour market. In that context, we see important risks to Canada’s economic outlook stemming from the recent decline in the price of oil and other commodities. As a net oil exporter, Canada will be affected by the lower prices, operating through several channels. The most immediate impact will be positive: a boost to consumers’ disposable incomes and spending. Lower oil prices will also benefit many sectors, such as manufacturing, by reducing production costs. Our latest Business Outlook Survey, which was published yesterday, showed that more firms than in previous surveys are anticipating declines in their input costs, thanks in good part to cheaper oil and cheaper commodities in general. The positive effect on the world economy and the resulting stronger growth would also be positive for Canada. A buoyant global economy would increase Canada’s non-energy exports, boost confidence and lead to improved business investment. However, these gains will be more than reversed over time as lower incomes in the oil patch and along the supply chain spill over to the rest of the economy. The decline in Canada’s terms of trade will also reduce the country’s wealth. The lower prices, if they are expected to persist, will significantly discourage investment and exploration in the oil sector. As I mentioned earlier, we are already seeing signs of this. Lower oil prices are also typically accompanied by a weaker Canadian dollar, and this time is no exception. The dollar’s depreciation by over 10 per cent against the U.S. dollar in the past six months will help cushion the economy from the impact of lower oil prices. Despite the mitigating factors I enumerated, lower oil prices are likely, on the whole, to be bad for Canada. Estimating the magnitude of that overall impact requires carefully analyzing the interplay between the various effects as they work through the economy. That is what we are doing as we prepare next week’s forecast. For the Bank of Canada, there are two main takeaways from the drop in oil prices. First, we will look through its immediate and temporary negative effect on total consumer price inflation. Second, we will closely monitor its broader impacts on growth and the delay it may cause to the economy’s return to its production potential. We will also watch for any impacts on the rotation of demand that we have begun to witness. Conclusion Allow me to conclude. The recent movements in oil prices have been dramatic, but they are not random. Once we sort through the different economic forces at play, we see that underlying the recent drop in BIS central bankers’ speeches oil prices is a surge in unconventional oil supply against the backdrop of slower growth of global demand. Over time, higher-cost oil is still likely to be needed to satisfy growing global demand, but prices could go lower, or remain low, for a significant period before those medium-term forces do their work. These developments are among the most important that the Bank of Canada takes into account in making monetary policy. We will continue to work to bring the Canadian economy back to its potential and return inflation sustainably to our 2 per cent target. However things play out, we have the tools to respond. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 21 January 2015.
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Stephen S Poloz: Release of the Monetary Policy Report Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 21 January 2015. * * * Good morning. Carolyn and I are delighted to be here to answer your questions about today’s interest rate announcement and our latest Monetary Policy Report (MPR). Let me begin with a few preliminary remarks. The recent drop in oil prices of course dominates this MPR, and dominated our policy discussions. There is considerable uncertainty around the outlook for oil prices and the implications for the economy. However, every credible scenario for oil left us with a significant issue for monetary policy. We have based our analysis on an assumption for oil prices of about US$60 per barrel for the next two years. Although this is above current levels, prices seem likely to move back above $60 in the medium term. The drop in oil prices is unambiguously negative for the Canadian economy. Canada’s income from oil exports will be reduced, and investment and employment in the energy sector are already being cut. There will be some offsets, but they are both partial and of uncertain timing: Canadian consumers will spend less on energy, but they could save some of the windfall rather than spend it; U.S. economic growth will be stronger, which – along with a lower Canadian dollar – should boost Canadian exports, but the speed of the export response is uncertain given the export capacity losses of the last decade. The Bank has been projecting a natural sequence of higher non-energy exports, higher investment and higher employment, which is needed to restore balance to the Canadian economy and reduce financial stability risks. This sequence is gaining traction and will be strengthened by the combination of lower oil prices, stronger U.S. growth and a lower Canadian dollar. However, these encouraging developments will be masked during the first half of 2015 by the impact of lower oil prices on the energy sector. Later in the year, growth in Canada’s nonenergy economy should re-emerge as our dominant trend. But the first-half slowdown represents a material setback in the Bank’s projected return to full employment and sustainable 2 per cent inflation. Let me now give you some additional insight into our policy deliberations. Based on our assumption of oil prices at $60 a barrel, our first projection implied that it would take until late 2017 for the economy to use up its excess capacity. This would mean significant downside risk to our underlying inflation profile, which is already below target because of the expected dissipation of one-time inflation effects from meat, communications and dollar depreciation. Obviously, these risks would be even more material if oil were to average $50 a barrel. Adding at least another year onto the period during which the economy would be operating below capacity and accepting more downside risk on inflation was considered unreasonable. Accordingly, we decided that it was appropriate to take out some insurance against that downside risk in the form of a lower interest rate profile. Policy insurance is a logical part of our risk management framework. Today’s action is intended to reduce the risk that our inflation path might move materially to the downside, as well as cushion the impact of lower oil prices and facilitate the economy’s sectoral adjustment to its new circumstances. The Bank has room to maneuver should its forecast prove to be either too pessimistic or too optimistic. BIS central bankers’ speeches We also considered carefully the matter of financial stability risks. For the past couple of years, we have seen periods of downside risk to the inflation profile, but the horizon over which we believed inflation would return sustainably to target remained reasonable, around two years. Financial stability risks have been elevated throughout, sometimes evolving constructively, sometimes edging higher. But they did not pose sufficient concern to make it necessary to alter policy and delay further the economy’s progress toward sustainable 2 per cent inflation. The drop in oil prices, however, has two separate effects relevant to policy. As already discussed, it materially increases the downside risk to underlying inflation, but it also increases the household debt-to-income ratio significantly. While it is true that a lower profile for interest rates may exacerbate household imbalances at the margin by encouraging more borrowing, the far more important effect will be to mitigate those imbalances by cushioning the decline in income and employment caused by lower oil prices. Ultimately, we believe the most reliable way to reduce financial stability risks is to do what we can to get the economy back to full capacity and sustainable inflation. Finally, we discussed the risk that by moving today we would surprise financial markets. We generally prefer that markets not be surprised by what we do, and believe that transparency around our analysis of the economy will minimize the scope for surprises. In that respect, we took comfort from the observation that the consequences of the drop in oil prices appear to be well understood, and that the possibility of a rate cut had begun to enter markets in the last couple of weeks. Moreover, given the magnitude of the shock, we concluded that the benefits of acting now rather than waiting would outweigh the costs of any short-term market volatility that might arise. With that, Carolyn and I would be happy to take your questions BIS central bankers’ speeches
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Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, to the Ottawa Economics Association, Ottawa, Ontario, 10 February 2015.
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Carolyn Wilkins: Minding the labour gap Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, to the Ottawa Economics Association, Ottawa, Ontario, 10 February 2015. * * * Accompanying charts can be found at the end of the speech. I would like to thank Stephen Murchison and Eric Santor for their help in preparing this speech. Introduction Thank you for the invitation. It’s a real pleasure to be here with my colleagues in Ottawa. As economists and policymakers, we are keenly aware of the continuing challenges facing the global economy. Even though Canada has had its share of setbacks over the last few years, we are fortunate to have been on a relatively steady growth path, with low and stable inflation. At least part of the credit has to go to sound economic and financial policies, as well as the prudent behaviour of our financial institutions. The U.S economy has been gathering strength and we have seen growth in Canada become more broadly based. But the Canadian economy is still operating below its potential, and the sharp drop in oil prices is a setback. That is why the Bank of Canada lowered the policy rate a couple of weeks ago. What I’d like to do today is walk you through the Bank’s assessment of how much room the economy has to grow and why we’re minding the labour gap. I’ll then talk about how lower oil prices will affect this picture, both domestically and globally. And finally, I’ll explain what all of this means for monetary policy. The divine coincidence You won’t be surprised when I say, as a central banker, that my objective is to achieve low, stable and predictable inflation. And so my interest in assessing the capacity of the Canadian economy is related to that goal. Of course, the 2 per cent inflation target is a means – it’s not the end. It is the best contribution monetary policy can make to the economic and financial well-being of Canada. And achieving the inflation target is consistent with closing the output gap and attaining full employment in a typical business cycle. Among economists, this is known as the “divine coincidence.”1 This business cycle has been far from typical. It spans a particularly destructive recession. Companies discarded unneeded capital and eliminated jobs. Many closed their doors for good. We know that a large number of firms in Canada simply disappeared, and with them, so did significant physical capital. But people are not like capital – the workforce is still available to be productively employed. It is critical that we consider the labour market for two reasons. First, we want to correctly gauge underlying inflation pressures in Canada. Understanding the degree of slack in the economy helps us avoid making policy decisions that could trigger inflationary or disinflationary pressures. Second, we don’t want to inadvertently stifle the rebuilding phase of an economy that will need to adjust to a lower price of oil. Right now, measures of economic Divine coincidence refers to a situation in which aggregate demand, long-run supply equilibrium and price stability are complementary objectives. See O. Blanchard and J. Galí, “Real Wage Rigidities and the New Keynesian Model,” Working Paper No 05–14, Federal Reserve Bank of Boston, October 2005. BIS central bankers’ speeches slack that focus exclusively on the labour market show greater unused capacity than broader measures do.2 The space between the gaps The Bank relies on a wide range of indicators to assess the degree of underlying inflation pressures. This is because there is uncertainty around any single one. Our indicators range from simple capacity utilization measures to results from the Business Outlook Survey and more complex statistical analyses.3 And we continue to build our tools to measure output gaps. Right now, simple measures of capacity utilization are actually somewhat above historical averages (Chart 1). Firms have been telling us that they are producing more with existing capacity rather than investing in new productive capital. Growth over the last few quarters has been mainly fuelled by a pickup in labour productivity. It has not been due to a material improvement in employment (Chart 2). In fact, employment growth last year was less than what would be consistent with growth in the economy’s potential.4 You can get a better sense of how important this is when you take a structural approach to measuring the output gap. We used a growth-accounting framework to help us estimate the output gap and the labour market gap.5 For those who are interested in learning more, we just posted a paper on this on our website.6 What this method tells us is quite important. Excess capacity in the labour market, the “labour gap,” was about 1 1/2 per cent at the end of last year, which is the equivalent to a shortfall of about 270,000 jobs.7 That’s roughly twice the size of the Bank’s overall assessment of the output gap. The beauty of this measure is that it accounts for demographic changes, and so we can get a better read on what is cyclical and what is structural. Prime-age and young workers are those who remain underemployed, while the contribution of older workers to the labour gap is close to zero (Chart 3). Another measure we use is the labour market indicator (LMI), which we started publishing on a regular basis this year. This indicator shows that the overall labour market has more room In the parlance of the 1960s and 1970s, we are seeing a divergence from Okun’s Law, which holds there is a negative statistical relationship between growth and unemployment. Okun’s Law is named for economist Arthur Okun who, in the early 1960s, showed that in the United States, unemployment tended to fall by 1 percentage point for every three percentage point rise in GDP. T. Macklem, “Information and Analysis for Monetary Policy: Coming to a Decision,” Bank of Canada Review (Summer 2002): 11–18. Monthly net job creation was about 10,000 in 2014, roughly 3,500 lower than what would be consistent with growth in potential. The integrated framework (IF) is based on the growth-accounting framework that decomposes potential GDP into contributions coming from trend labour input (hours worked) and trend labour productivity (output per hour worked). On the trend labour input side, the IF uses an empirical model that largely depends on demographic developments, as well as other factors such as school enrolment and disincentives linked with employment insurance. On the trend labour productivity side, the approach links the capital stock with investment to identify trend capital deepening and uses a combination of filters and detailed analysis of variables such as investment in machinery and equipment and research and development to estimate trend total factor productivity. L. Pichette, P. St-Amant, B. Tomlin and K. Anoma, “Measuring Potential Output at the Bank of Canada: The Extended Multivariate Filter and the Integrated Framework,” Discussion Paper No. 2015–1, Bank of Canada, January 2015. The estimate of 270,000 jobs corresponds to approximately 1.5 per cent of the Bank’s structural estimate of trend employment in 2014Q4. BIS central bankers’ speeches for improvement than the headline unemployment rate would suggest.8 The unemployment rate is currently close to its post-recession low of about 6 1/2 per cent, while the LMI has fluctuated in a narrow range around 7 1/2 per cent since the end of 2011 (Chart 4). There are a number of factors that explain this difference. Average hours worked remain low, and more than one in four people who have part-time jobs would prefer to work full-time.9 At the same time, the participation rate of prime-age workers – the core of our labour market – actually fell substantially in 2014. And average unemployment duration is lingering close to its post-crisis peak, at about 21 weeks. That is a long time to be unemployed. You might be starting to lose your skills, you’re adjusting your lifestyle, and you may even be thinking about dropping out of the labour force. That is valuable capacity at risk. It’s not surprising, then, that wage increases remain subdued despite strong productivity growth. Consequently, there are currently no inflation pressures coming from the labour market overall. Some of the prolonged weakness in labour markets is to be expected. The quality of jobs erodes in a downturn.10 Finding a job is harder. The process of matching workers to jobs deteriorates rapidly and is slow to improve. Firms wait for greater certainty about the recovery before they hire, and workers hesitate to leap to new jobs when they feel insecure. The pace of improvement in this matching process depends on the duration and the strength of the expansion.11 The pace of growth is something that monetary policy influences directly. Setting the right monetary conditions, in the context of our inflation targeting regime, is the best thing we can do for the labour market. Oil matters The recent drop in oil prices matters a lot for how the recovery continues to unfold. Canada is a net exporter of energy, and so the price of oil has implications for both the speed and distribution of growth. Oil prices are down by about 50 per cent since last June, and that has caused a significant drop in our terms of trade – the price of what we export relative to the price of what we import.12 The fall in oil revenues will be large and is occurring already. Overall domestic demand will weaken as the impact of this decline spreads through the Canadian economy via channels such as wealth, income, and interprovincial trade. If oil prices were to average The LMI looks much deeper into the labour market than the unemployment rate by combining eight indicators of labour market health: underutilization rate, unemployment rate, long-term unemployment, separation rate, participation rate (prime-age), wage growth, average hours worked, and job-finding rate. The LMI is scaled to be comparable with the unemployment rate, and thus provide a simple benchmark against which to judge whether the unemployment rate is evolving in a manner consistent with broader labour market conditions. See K. Zmitrowicz and M. Khan, “Beyond the Unemployment Rate: Assessing Canadian and U.S. Labour Markets Since the Recession,” Bank of Canada Review (Spring 2014): 42–53. Increases in involuntary part-time work were observed across age groups and accounted for virtually all of the increase in the share of part-time employment. For additional details on the evolution of labour force participation rates and part-time employment across age groups and regions, see C. Cheung, D. Granovsky and G. Velasco, “Changing Labour Market Participation Since the Great Recession: A Regional Perspective,” Discussion Paper No. 2015–2, Bank of Canada, February 2015. L. B. Kahn and E. McEntarfer, “Employment Cyclicality and Firm Quality,” NBER Working Paper No. 20698, November 2014. P. Diamond and A. Sahin, “Shifts in the Beveridge Curve,” Federal Reserve Bank of New York Staff Report No. 687, August 2014. T. Lane, “Drilling Down – Understanding Oil Prices and Their Economic Impact” (speech to Madison International Trade Association, Madison, Wisconsin, 13 January 2015). BIS central bankers’ speeches $60 per barrel and monetary policy did not respond, gross domestic income would be about 4 1/2 per cent lower by the end of 2016.13 That would affect incomes of Canadians. While some regions will clearly bear more of the brunt than others, the impact will be felt across the country. Nearly one-third of the goods and services purchased by the Alberta energy industry are drawn from other provinces – and so are the workers.14 Lower incomes would also lead to an increase in household imbalances. We laid all this out in our January Monetary Policy Report. Many of the negative effects of lower oil prices on growth happen swiftly. Energy-related firms are already paring back investment and hiring intentions. We expect capital investment in the oil and gas sector to fall by about 30 per cent in 2015. This is huge given the importance of investment in this sector for overall growth. Current spot prices are below fullcycle break-even cost estimates for most oil sands projects, which can typically range from $60 to $100 per barrel. So unless firms cut costs and become more efficient, continuing production will not make good business sense. Fortunately, there will be some offsets, although these will take longer to materialize and are uncertain. The stronger U.S. economy and a weaker Canadian dollar will cushion the impact of lower oil prices, and so we expect some further improvements in the non-energy export sector. Our Business Outlook Survey shows manufacturers are more positive about investment intentions and employment. This is important for provinces such as Ontario and Quebec that have supply-chain links to the energy sector. If low oil prices persist, they will spur a significant reallocation of workers across sectors and regions.15 We’ve seen this happen in previous oil price cycles, as energy-intensive regions gear up and then gear down. This affects labour market conditions across the country. Because oil prices were so strong up until mid-last year, there is currently no slack (and there was even a little excess demand) in provinces west of Ontario. All of the current slack in labour markets is in provinces east of Manitoba (Chart 5). This will change as the economy adjusts. A relatively hot spot in the Canadian economy is now cooling. How quickly the adjustments happen depends on the timing of contracts and firms’ expectations of the depth and duration of oil-price weakness. We’re already seeing signs that the stream of workers commuting to Alberta from other parts of the country is slowing. Fly-in-fly-out contract workers, many of whom are from Atlantic Canada, may be the first to feel the effects.16 Inflation easing globally Oil prices are also affecting the global economy in ways that matter to Canada. First, lower prices offer a much-needed boost to global growth. Second, they are pushing down global inflation. I’ll start with the positive effect on global growth. It couldn’t have come at a better time, given the excess capacity we see in many countries, especially in advanced economies.17 Global The impact on income is relative to a scenario in which the price of Brent crude remains at US$110. See Bank of Canada Monetary Policy Report (January 2015): 25–26. “Fuel for Thought: The Economic Benefits of Oil Sands Investment for Canada’s Regions,” Conference Board of Canada Report, October 2012. P. Antunes and K. Beckman, “Regional Shake Up: The Impact of Lower Oil Prices on Canada’s Economy,” The Conference Board of Canada, 20 January 2015. The Conference Board estimates that about $375 million in income from fly-in-fly-out workers accrued to Atlantic Canadians in 2014. See P. Antunes and K. Beckman, “Regional Shake Up: The Impact of Lower Oil Prices on Canada’s Economy,” The Conference Board of Canada, 20 January 2015. We estimate that the excess supply is about 1.0 to 2.0 per cent at the global level. BIS central bankers’ speeches labour market conditions are not any better, with unemployment rates often above 10 per cent. So, labour gaps are significant. In some places, we are seeing long-term unemployment, involuntary part-time work, and other indicators of hysteretic effects in labour markets.18 It’s no surprise, then, that real wage growth has stagnated. The share of income that is going to labour has been falling, continuing a trend that started three decades ago (Chart 6). The decline implies that more income is going to those with a higher savings rate. So they aren’t spending the income. Fortunately, lower oil prices are providing some offset by putting money back in people’s wallets. Overall, lower oil prices will boost global economic growth, particularly in the United States and China, Canada’s major trading partners. So, we’ve talked about growth. Let’s turn now to the effect that the drop in oil prices is having on inflation. Lower headline inflation increases the risk that inflation expectations become unanchored, particularly in the euro area, where inflation forecasts have been revised down (Chart 7). Clearly, monetary policy actions taken by the European Central Bank and other central banks around the globe will help to anchor inflation expectations. Canada has a very open economy, so the boost in world growth is good for us. Global inflation or disinflation trends matter, too. Our work shows that up to a quarter of the variance in core inflation in Canada can be explained by a common global factor. That is, developments that affect inflation at the global level can have an impact on inflation here at home. Fuel in the tank Now, let me turn to what this means for monetary policy. In the days leading up to our policy decision on 21 January, we considered the implications of the fall in oil prices and whether our policy rate of 1 per cent was still appropriate. Monetary policy was already stimulative. Yet our initial projections suggested that if oil prices were to settle around $60 per barrel, and we did not change the policy path we had anticipated last October, it would take until late 2017 for the output gap to close. We thought that was an unreasonably long time frame, especially coming on the heels of successive delays in closing the output gap and achieving full employment. The oil-price shock increased the downside risks to inflation, particularly given the uncertainty about the strength and timing of the offsets coming from the stronger U.S. economy and a weaker Canadian dollar. That, in and of itself, warranted a response. Lower oil prices also increased the risks to financial stability because they could trigger the household vulnerabilities that we had warned about in our Financial System Review. In order to meet our inflation target over a reasonable time frame, while insuring against financial stability risks, we lowered the policy rate. What we expect to achieve extends beyond the 25-basis-point cut itself. Our policy action has eased monetary conditions by affecting the full range of asset prices. This is the normal transmission of monetary policy and will support the sectoral adjustment needed to strengthen investment and growth. It will also support financial stability by helping offset the reduction in incomes and the risk of higher and more persistent unemployment. A variable is said to exhibit hysteresis if there is no tendency for it to revert to some mean value after a disturbance causes it to change. The variable remains permanently at that new value until another shock disturbs it. For evidence of hysteretic effects in the United States, see D. Reifschneider, W. Wascher and D. Wilcox, “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy,” Finance and Economics Discussion Series 2013–77, Board of Governors of the Federal Reserve System, 2013. BIS central bankers’ speeches With this new starting point, we reduced our growth expectations for the first half of 2015 to 1 1/2 per cent. We expect the economy to then rebound in the second half of the year, reaching its full capacity around the end of 2016 – a little later than expected in October. Weaker oil prices will pull down the inflation profile, more than offsetting the direct effect on prices that we are seeing from a lower Canadian dollar. We expect headline inflation to fall temporarily below 1 per cent this year and move back up to target next year. The labour market will recover as the output gap closes and the divine coincidence that I talked about earlier will eventually be re-established. This happens as output increases, firm creation and business investment picks up, and capacity is rebuilt. As this occurs, the signals coming from the labour market gap and output gap will become more consistent. Of course, there is a risk that additional capacity won’t be added fast enough to keep the output gap from temporarily going positive. An economy pushing up against the limits of its capacity may be just what is required to signal the need for additional investments and to draw workers back into the labour force. There is uncertainty about how much potential can be rebuilt, and we need to take this into account in our risk-management approach to monetary policy. Our inflation-targeting framework gives us flexibility on the timing to achieve the inflation target while also taking into account other important dimensions of the economy – such as financial stability and the economy’s potential.19 Stifling the rebuilding phase of the recovery could mean lost economic opportunity. That being said, if potential output growth turns out to be lower than we think, we have the tools to bring inflation back to target. Conclusion There is no doubt that the Canadian economy has room to grow. The stronger U.S. economy, a lower dollar and our monetary policy response will work to keep the recovery in Canada on track and to get inflation sustainably back to target. There will be some adjustments across the country as non-energy exporters take on the mantle of growth. As this happens, Canadian firms and workers will need to demonstrate the impressive ability to adjust that we have seen in the past. Monetary policy is contributing to this effort by providing an environment of low and stable inflation, while supporting the adjustments needed to return the economy to sustained and balanced growth. We’ll get there and it will be a very good thing for Canada. M. Carney, “A Monetary Policy Framework for All Seasons” (speech to U.S. Monetary Policy Forum, New York, New York, 24 February 2012). 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 Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Association québécoise des technologies, Mont-Tremblant, Quebec, 19 February 2015.
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Agathe Côté: Inflation expectations and monetary policy Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Association québécoise des technologies, Mont-Tremblant, Quebec, 19 February 2015. * * * Accompanying charts can be found at the end of the speech. I would like to thank Michael Ehrmann and Marc-André Gosselin for their help in preparing this speech. Introduction Thank you for inviting me to be with you today. I am delighted to be here. At the Bank of Canada we need a thorough understanding of what is happening in the economy – not only at the aggregate level, but also at the level of individual agents, such as entrepreneurs like yourselves. You have an impact on the economy, and thus on the Bank. Similarly, the Bank has an impact on business conditions, and in turn on you. This relationship is well illustrated by the topic of my speech today: inflation expectations and the role they play in the conduct of monetary policy. Central banks have long understood the importance of inflation expectations. It is widely accepted that a key benefit of an inflation-targeting system, such as the one we have had in Canada since 1991, is that it provides a good anchor for expectations. That being said, there are still many questions about how people form their expectations. While central banks exercise a great deal of influence on expectations, there are many other factors that can come into play. So, therefore, it is critical to carefully measure and interpret the signals sent by a variety of economic agents. In my remarks today, I will explain why inflation expectations are so important to monetary policy and what role they might have played in the puzzling evolution of inflation that followed the financial crisis. I will also talk about the survey that the Bank of Canada has just created to better understand the evolution of expectations. Finally, I will turn my attention to current events and talk about today’s inflation expectations, including those of the Bank, in the wake of the steep decline in oil prices. The surprising evolution of inflation after the crisis The Bank of Canada conducts monetary policy to maintain the inflation rate at 2 per cent – the midpoint of a 1 to 3 per cent target range. Since there is a lag in the transmission of monetary policy, the Bank needs to identify the factors that are likely to have a persistent effect on inflation. The main determinant of underlying inflationary pressures is the output gap – the difference between actual output and potential output. When the demand for goods and services causes the economy to operate near capacity, there is upward pressure on prices. Conversely, a shortfall in demand tends to put downward pressure on prices. However, a wide variety of factors can complicate the analysis of inflationary pressures, such as the transitory impact of exchange rate fluctuations or sector-specific price movements. In recent years, the behaviour of inflation in Canada and other advanced economies has been surprising, even when we take into account these temporary factors (Chart 1). Indeed, following the global financial crisis, the dynamics of inflation gave rise to two puzzles. The first emerged in 2010–11, when inflation rates were consistently higher than expected, BIS central bankers’ speeches even as economic slack reached its highest level in recent history (Chart 2 and Chart 3). The unexpected stability (or even, in some cases, increase) in inflation during this period led some economists to liken inflation to the dog that did not bark in the Sherlock Holmes story.1 The second puzzle was initially observed in 2012 (and lasted until at least mid-2014): inflation fell rapidly at the same time that the global economy was recovering and the output gap was shrinking. Once again, inflation surprised us – this time by its weakness. The contribution of household inflation expectations Given inflation’s importance to central banks, it is not surprising that a number of studies have examined its unusual behaviour during the crisis. Several hypotheses have been proposed, including the possibility that the sensitivity of inflation to the output gap, or to its persistence, has changed, or that the extent of excess capacity had been misjudged. It is also possible that the effects of exchange rate fluctuations, commodity prices or the increasing trade with China were underestimated. Our own work at the Bank, as well as that of other researchers, suggests that inflation expectations can help us resolve the twin puzzle. Using econometric models that allow us to quantify the effect of individual variables on inflation, we learned that including household expectations with the usual determinants of inflation enabled us to explain a good portion of inflation dynamics in advanced economies since the crisis.2 Household expectations increase the predictive power of models, even when those models already incorporate the expectations of professional forecasters. In the United States, household expectations help explain the apparent stability of inflation after the crisis, as they increased following the rapid rise in oil prices and counteracted the output gap’s dampening effect.3 In Europe, where the economic recovery has been sluggish in recent years and some countries have recently reported negative inflation, falling household expectations have contributed to the decline in inflation. Households’ inflation expectations seem particularly useful in explaining the post-crisis dynamics of inflation, because they have exhibited greater variability than those of professional forecasters (Chart 4). For Canada, it is difficult to say what role household expectations could have played, because we do not measure them. I will return to this later. We know, however, that business expectations have remained well anchored to the target. Indeed, the Bank’s Business Outlook Survey shows that, since the second quarter of 2009, at least 80 per cent of businesses canvassed have reported that they expect inflation to remain between 1 and 3 per cent over the next two years. This stability contributed to the resilience of inflation during the years immediately following the crisis (Chart 5). Regarding the subsequent decline in inflation, the Bank’s analysis has highlighted the importance of increased competition in the retail sector. Indeed, the expansion of major retailers and the arrival of new ones in Canada have profoundly changed the retail International Monetary Fund (IMF). 2013. World Economic Outlook (April), ch. 3. Friedrich, C. 2014. “Global Inflation Dynamics in the Post-Crisis Period: What Explains the Twin Puzzle?” Bank of Canada Working Paper No. 2014–36. Coibion, O., and Y. Gorodnichenko. 2015. “Is the Phillips Curve Alive and Well after All? Inflation Expectations and the Missing Disinflation.” American Economic Journal: Macroeconomics 7 (1): 197–232. BIS central bankers’ speeches landscape. The growing popularity of online shopping and new technologies have also contributed to intensifying competition.4 The impact of this increased competition, together with the large output gap, helps explain why inflation fell into the lower zone of the target range from mid-2012 to mid-2014.5 Today, these same factors are contributing to underlying inflation being below 2 per cent in Canada. Overall, and even if Canada’s experience was slighty different, recent work suggests that the behaviour of expectations could explain part of the unexpected evolution of inflation in advanced economies since the crisis. The importance of inflation expectations for monetary policy Why are inflation expectations so important for understanding observed inflation? After all, if forecasts about the weather have no influence on it, why is it any different with inflation? In fact, the observed inflation rate reflects actions that people take today in light of their expectations of future inflation. For businesses, inflation expectations influence wage negotiations, price setting and financial contracting for investment; for households, expectations have an impact on consumption and savings decisions. If workers expect that the prices they currently face will increase in the future, they will ask for wage adjustments now, and entrepreneurs will do the same for the prices of their goods or services. Moreover, the key role played by household expectations in recent inflation dynamics could be partly explained by the fact that they approximate the expectations of small and medium-sized enterprises, which make up the vast majority of businesses in the developed economies. The importance of inflation expectations was made clear to central banks in the 1970s and 1980s. In those years, inflation was high, volatile and unpredictable. Households and businesses relied on past inflation to predict its future level. Even with high interest rates, central banks struggled to contain inflation, because the anticipation of high inflation was a self-fulfilling prophecy. The adoption of an inflation target helped correct the situation. In Canada, thanks to the public commitment made by the Bank in 1991 (and the Bank’s success in fulfilling it over time), Canadians gradually began to expect that inflation would remain close to 2 per cent (Chart 6).6 Since then, Canadians have been able to make decisions about their spending and savings with greater confidence, which has been favourable for investment and has contributed to improving the functioning of the labour market. It is crucial that inflation expectations be well anchored, as it allows central banks to attain their inflation targets while reducing the volatility of other important variables, such as interest rates and output. Among other benefits, central banks will be less likely to reach the zero lower bound on interest rates. Consider the growing use of smartphones, which makes shopping considerably easier by allowing consumers to compare prices in real time. Unlike similar work on the United States, our research on Canada has not allowed us to identify any change in the sensitivity of inflation to the size or persistence of the output gap. Nor have fluctuations in the exchange rate or the prices of imported goods helped us solve the dual puzzle. With regard to the situation in the United States, see R. G. Murphy, “Explaining Inflation in the Aftermath of the Great Recession,” Journal of Macroeconomics, 2014, 40: 228–244. The credibility of the target is reflected, for instance, in wage bargaining: While 21 per cent of collective agreements signed between 1985 and 1989 included a cost of living adjustment clause, by 2014 only 4 per cent of them did. BIS central bankers’ speeches Recent work conducted by the Bank confirms that inflation expectations are better anchored in countries that pursue an inflation target.7 Moreover, this research suggests that the behaviour of expectations might be asymmetrical, depending on whether inflation lies above or below the target. There is a greater risk that expectations will become unanchored when inflation is persistently low, as is currently the case in a number of economies. This could have implications for monetary policy: when inflation is low for an extended period, central banks might have to expect a longer delay in returning it to the target. Several indicators are better than one Given the importance of inflation expectations, central banks closely monitor the evolution of several indicators that measure expectations. We are of course interested in the level of expectations – they are a key determinant of future inflation – but also in the degree of uncertainty surrounding those expectations and their sensitivity to observed inflation. These measures provide important signals about the extent to which expectations are anchored at the target. In addition to monitoring expectations over various time horizons, we also compare the expectations of various types of economic agents: financial markets, professional forecasters, households and businesses. Each type of indicator has strengths and weaknesses,8 and the signals will be more credible if they are corroborated by more than one indicator.9 Expectations are not static. It is normal to see them fluctuate in response to changes in business conditions. Currently, for example, short-term inflation expectations are decreasing in Canada and elsewhere, owing to the fall in oil prices.10 This is not surprising, considering that the prices of frequently-purchased consumption goods, such as gasoline, typically have a more pronounced impact on expectations.11 However, if the inflation target is credible, we should not see significant fluctuations in medium- and long-term expectations; if it is not, economic agents will tend to modify their behaviour, thus compromising the effectiveness of monetary policy. In the second half of 2014, long-term inflation expectations derived from financial instruments fell in some advanced economies, including Canada, but forecasters’ expectations over the same horizon remained stable and very close to central bank targets (Chart 7). In most economies, the risk that expectations will become unanchored therefore appears limited. The Bank’s new survey As I mentioned earlier, we do not have indicators of household inflation expectations in Canada. The Bank recently decided to fill this gap by creating a new survey. Ehrmann, M. 2014. “Targeting Inflation from Below – How Do Inflation Expectations Behave?” Bank of Canada Working Paper No. 2014–52. Cunningham, R., B. Desroches and E. Santor. 2010. “Inflation Expectations and the Conduct of Monetary Policy: A Review of Recent Evidence and Experience.” Bank of Canada Review (spring): 13–25. The importance of monitoring the inflation expectations of various economic agents has been recognized for a long time. What recent research has highlighted, however, is that we must also apply this approach to our models. Compared with October, the February Consensus Economics forecast for total CPI inflation for 2015 declined by 1.1 percentage points to 0.8 per cent. The forecast for total CPI inflation for 2016 is 2.1 per cent. There is also a slight downward shift in the results of the Bank’s winter Business Outlook Survey. Ehrmann, M., D. Pfajfar and E. Santoro. 2014. “Consumer Attitudes and the Epidemiology of Inflation Expectations.” Bank of Canada Working Paper No. 2014–28. BIS central bankers’ speeches To that end, the Bank examined the various techniques used to measure the inflation expectations of households elsewhere in the world and largely based its approach on the one created by the Federal Reserve Bank of New York.12 The Bank’s new quarterly survey is an online poll of 1,000 Canadian consumers. It measures both the inflation expectations of participants over various time horizons and the uncertainty surrounding them. A preliminary analysis of the responses from the first wave of the survey, conducted last November, is promising. Indeed, the inflation rate perceived by households is similar to that measured by the CPI over the past year. As well, when households were asked to evaluate the probability of various inflation outcomes over the next two years, their answers centred around the Bank’s 1 to 3 per cent target range. This is an encouraging sign that household expectations are anchored to the target. Our new household survey also covers a wide array of other economic expectations that will inform the Bank, and Canadians in general, on issues ranging from labour market prospects to personal finances. The power of our new tool will truly reveal itself after we have conducted the survey several times, giving us the ability to compare results over time and analyze trends. We will present detailed findings later this year after taking the time to analyze the results carefully. The fall in oil prices creates disinflationary pressures After talking about the inflation expectations of other economic agents, I would be remiss if I didn’t mention the Bank’s expectations. If the expectations of households and businesses are central to the decisions they make, the same is also true of the Bank. Since mid-2014, inflation has risen to around our 2 per cent target. This increase in inflation is being temporarily fuelled by the depreciation of the dollar since the beginning of 2013, as well as by some sectoral factors, particularly higher prices for meat and communications services. Since there is still material excess capacity in the economy and competitive pressures remain intense in the retail sector, the Bank estimates that underlying inflation remains below target. On top of this, the economy is also faced with the steep decline in oil prices. Its impact is already being felt, and the inflation rate fell to 1.5 per cent in December. The Bank predicts that this rate will continue to decline, bottoming out at a level slightly above zero in the second quarter of 2015 (Chart 8). In light of the volatility of oil prices, it is possible that inflation will dip into negative territory for a brief interval. Rest assured: even if inflation turns negative for some time, that would not constitute deflation, which requires a generalized decline in prices. When inflation expectations are solidly anchored, as is now the case in Canada, there is no reason to fear deflation. The repercussions of falling oil prices will be felt well beyond their direct impact on the consumer price index. As the Bank explained in its January Monetary Policy Report, lower oil prices will have an unambiguously negative impact on the Canadian economy. This shock will delay the economy’s return to full capacity by undermining both investment in the oil sector and gross domestic income. When oil prices fall, declining revenues from the oil sector are transmitted to the Canadian economy through a reduction in personal wealth via the impact on incomes and stock holdings. Interprovincial trade is also affected. In Western Canada, for example, purchases of machinery, primary metals and chemical products The Fed’s survey is the product of several years of research and experiments conducted by a group of economists and psychologists. See O. Armantier, W. Bruine de Bruin, S. Potter, G. Topa, W. van der Klaauw and B. Zafar, “Measuring Inflation Expectations”, Annual Review of Economics, Vol. 5 (2013): 273–301. BIS central bankers’ speeches manufactured by companies in Central Canada will decrease. Together, these effects will outweigh the benefits derived from the decline in oil prices on the energy bills of households and businesses. The net impact of this shock is significant: assuming no monetary policy response to the shock, we have calculated that average household disposable income would be reduced by 3 per cent by the end of 2016. Moreover, through its impact on the real economy, the decline of about 50 per cent in the price of oil since June would knock roughly one-half point off the underlying inflation rate during the same period. It is against this backdrop that the Bank lowered its key policy rate by a quarter of a point in January. The Bank’s policy action is intended to provide insurance against downside risks to the inflation profile and financial stability risks, support the sectoral adjustment needed to strengthen investment and growth, and bring the Canadian economy back to full capacity and inflation to target around the end of 2016. By doing so, it should also keep inflation expectations well anchored to the target. The concept of insurance is important and should be explained in greater detail. Policy insurance is a logical part of our risk management framework for monetary policy. There is nothing mechanical about it. The cut in policy rate is intended primarily to provide insurance against the downside risks to inflation. Many of the negative effects of lower oil prices on growth happen swiftly. There will be some offsets, such as the stronger U.S. economy and a weaker Canadian dollar, but there are risks with regard to the timing and magnitude of these compensating effects. On March 4 we will come to our next interest rate decision. That decision will be based on a careful examination of how the economy, and the risks, are evolving. Conclusion Allow me to conclude. Inflation expectations are central to the conduct of monetary policy. The Bank has recently developed a new indicator of inflation expectations to enhance its other indicators. We are therefore better equipped to closely monitor and analyze expectations. I hope that my remarks have given you a clearer idea of the Bank’s work and the challenges it faces. It is possible that, some day, one of our regional representatives will contact you to request your participation in the Business Outlook Survey. You might also be asked to participate, as a consumer, in our new online survey. In either case, I ask you to give us some of your time: this will help us to do our work better. The Bank of Canada, in turn, will continue to contribute to the economic welfare of households and businesses by maintaining a level of inflation that is low, stable and predictable. Our inflation target has gained a great deal of credibility over time, which has helped to hold inflation expectations near our goal, but we are not taking this success for granted – we remain vigilant. I thank you for your attention. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Inaugural address by Mr Stephen S Poloz, Governor of the Bank of Canada, for the Western University President's Lecture, London, Ontario, 24 February 2015.
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Stephen S Poloz: Lessons new and old – reinventing central banking Inaugural address by Mr Stephen S Poloz, Governor of the Bank of Canada, for the Western University President’s Lecture, London, Ontario, 24 February 2015. * * * Introduction I am delighted to be back at Western, and honoured to be asked by President Chakma to give the inaugural address in the President’s Lecture Series. While preparing for today, I did a little reminiscing, and I was struck by how prophetic some of the lessons I learned here back in the late 1970s have turned out to be. Many of us came to Western at that time to learn from the high-profile duo of David Laidler and Michael Parkin. I can remember David Laidler telling me, “Steve, monetary targets will help keep us out of trouble, but if we do get into trouble, they might not get us out.” And then there was Michael Parkin, who later was my thesis adviser, who said, “Steve, there are lots of monetary policy rules that deliver the same inflation outcome, but each will have very different consequences for the economy.” Well, those words ring very true 35 years later, particularly given our experience over the past decade. While central banks were diligently maintaining low and stable inflation, we witnessed the emergence of massive imbalances, an unprecedented expansion in leverage, a global financial crisis and a synchronized downturn in the world economy. Today, as we try to apply the lessons learned, we find ourselves weighing a wide range of consequences in charting the future course of monetary policy. Thanks to some deft policy-making, the global economy avoided, barely, a second Great Depression. That said, the Great Recession has been very painful. Indeed, more than six years after the crisis, emergency monetary policies remain in place in many economies. In short, we are still a long way from home and the headwinds are strong. The experience of the past decade makes a pretty strong case that central banking needs to be reinvented. Keeping inflation on track certainly was not sufficient to keep us out of trouble. Some would even argue that the tranquility fostered by successful inflation targeting helped to spawn the crisis by leading investors and financial intermediaries to take excessive risks. At the very least, it seems to me that we need to take account of a wider range of economic and financial consequences while targeting low inflation. An evolution of central banking is already under way, supported by recent experience and new research. Today, I hope to inspire economists here and elsewhere to join these efforts. The lessons of history It is worth thinking back to how central banks operated under the gold standard in the 19th and early 20th centuries. At that time, keeping the financial system stable – preventing banking panics – was the primary objective. Under most circumstances, currency could be converted into gold, so the price of gold served as a nominal anchor – a type of inflation rule – for the economy. Central banks provided an elastic supply of money, expanding or shrinking that supply to meet demand and maintain the fixed gold price. The aim was to avoid the wide swings in liquidity and interest rates that often heralded banking crises. The central bank of that era also supported financial stability by acting as the lender of last resort, thereby preventing a liquidity shortage in one bank from becoming a full-blown panic. The Bank of Canada – which, by the way, will celebrate its 80th anniversary in a couple of weeks – was established during the Great Depression with these objectives in mind, BIS central bankers’ speeches although there was a hint of a more ambitious set of objectives, given the state of the economy at the time. The Bank of Canada Act instructed the Bank to regulate credit and currency in the best interests of the economic life of the nation and to protect the external value of the currency, but was largely silent about how to accomplish these tasks. In the event, the gold standard proved to be too rigid a framework for monetary policy. In 1944, the Bretton Woods Conference gave the world a system of pegged but adjustable exchange rates, replacing the gold standard with a U.S.-dollar standard, which in turn was pegged to gold, at US$35 per ounce. This system also proved unsatisfactory in several respects. There is no need to go into detail, but the stresses of the early 1970s proved too much, and the Bretton Woods system collapsed, launching an era of high global inflation and a search for a new framework for monetary policy formulation. A number of central banks, including the Bank of Canada, then adopted monetary targets as a means of getting inflation under control. Slow the growth of money and you slow the rate of inflation with minimal consequences for economic growth was how the theory went. This was the state of play when I came to Western in 1978, and there was solid academic support for that policy framework. But by the time I arrived at the Bank of Canada in 1981, there was growing disenchantment with monetary targeting, as the link with inflation was proving to be unreliable. For practical reasons, the target had to be abandoned. But as former Governor Gerald Bouey famously put it in 1983: “We did not abandon M1, M1 abandoned us.” The search for a better monetary policy framework continued through the rest of the 1980s, both in central banks and in academia. The questions were very fundamental: What is the optimal monetary policy? What is the best anchor for that policy? And should central bankers be bound by rules for policy, or should they be afforded some discretion? If so, how much? As you all know, a consensus emerged that central banks should pursue inflation targets directly, rather than targeting an intermediate variable such as the money supply. In 1991, the Bank of Canada became the second central bank (after New Zealand) to adopt inflation targeting. And over the next 10 years, many other major central banks joined the inflationtargeting club. At the time, it was hard to argue with the results. Inflation targeting was seen as a key contributor to the “Great Moderation” – a period of about 15 years of steady economic growth and low and stable inflation in most advanced economies. In Canada, and elsewhere, consumers and businesses could make longer-term financial plans with more confidence. Interest rates were lower, and economic cycles were more moderate. Unemployment was lower and less variable than in the past. This success contributed to the widespread belief that maintaining low and stable inflation was the best, indeed the only, contribution that a central bank could make to the economy’s performance. Countries with dual central bank mandates – low inflation and strong growth or low unemployment – could rely on the “divine coincidence” that stable inflation would emerge only when the economy was operating at full capacity. And what about the issue of financial stability? Central banks would remain available as lenders of last resort, the purpose for which they were originally created, but financial stability issues were seen primarily as the responsibility of regulators and, perhaps, a problem for emerging-market economies with banking systems that weren’t fully developed. This policy consensus began to wobble as financial stability concerns grew during the mid2000s, and by 2007 it had fallen apart. Confidence that keeping inflation low and stable would keep us out of trouble had bred complacency, and complacency bred calamity. We all know the rest of the story. So far, the crisis has cost the global economy over US$10 trillion BIS central bankers’ speeches in lost output, and we are discovering just how ineffective our policies can be in getting us out of trouble, once in. Crisis and response – early lessons There is no need to document all the monetary actions that have been deployed since 2008. Suffice to say that, with interest rates at all-time lows, in some cases even less than zero, and massive expansions of some central bank balance sheets, monetary policy is still pushing flat out – and yet still we see a lacklustre outcome for the world. Obviously, the headwinds we face are powerful ones, and they are dissipating only gradually. Although we are not out of the woods yet, it is nevertheless the right time to be thinking about what monetary policy should look like once we are. The first lesson of the crisis is that low and stable inflation is a necessary, but not sufficient, condition for financial stability. The low nominal interest rates that came with low and stable inflation led investors to increase leverage and risk tolerance in a desire to boost their returns, and similarly encouraged consumers to ramp up borrowing. We learned that these vulnerabilities can build up over time, raising the risk of a crisis even while the economy looks to be safe and sound. The second lesson is that, while imbalances can make an economy vulnerable, debt-fuelled imbalances are particularly hazardous. That’s because when there is a shock – such as the financial crisis – it can take a very long time for balance sheets to be repaired, and the economy simply does not recover in the usual way. The massive price tag for cleaning up the crisis has demonstrated the value of preventing these imbalances from building up in the first place. The third lesson is that maintaining a low and stable inflation rate is a two-edged sword. Yes, there are the expected benefits in terms of the efficient functioning of the economy and financial markets. But there is a downside, too: the low equilibrium level for nominal interest rates means that central banks have very little room to manoeuvre when there is a large negative shock, such as the one we encountered in 2008. Being constrained by the effective lower bound for interest rates has clearly prolonged the global economy’s adjustment. A fourth lesson is that policy-makers cannot safeguard domestic financial stability simply by focusing on the safety of their domestic banking system. Policy-makers didn’t fully understand the risks associated with new forms of financial intermediation – complex instruments like collateralized debt obligations. And they didn’t comprehend how interconnected the global financial system had become, and how easily shocks can be amplified and transmitted. Responses to some of these lessons are already being put into practice, and there is considerable supporting research, both at the Bank and in academia. At the regulatory level, the G-20 countries recognized the need to make the world’s financial system safer. The Financial Stability Board was given the task of coordinating the development of minimum global standards around capital, liquidity and resolvability, as well as for market infrastructure, to reduce the risk and severity of any future financial crisis. By and large, the FSB has delivered and countries have begun to implement the new standards. On the monetary policy front, central banks must, at the very least, understand emerging financial stability risks when conducting monetary policy. All central banks have upgraded their capacity in this area. The Bank of Canada now takes a more structured approach to our analysis in our semi-annual Financial System Review. Specifically, we use more and better data to assist our financial system monitoring, backed by deeper conversations and models where appropriate, to make more informed judgments about financial stability risks. We’ve added other potential sources of vulnerability, such as the balance sheets of households, companies and banks, to our macroeconomic models. BIS central bankers’ speeches We’re also making progress toward a better understanding of how monetary policy actions influence risk taking. For example, when a central bank cuts interest rates to cushion the economy from a shock, the hope is that people will borrow more at that lower interest rate and spend more money. What this means is that financial imbalances are a necessary byproduct of monetary policy action, especially if the action is prolonged, so these additional adjustment dynamics must be fully taken into account when conducting policy. Clearly, though, incorporating financial stability into our monetary policy framework remains a work in progress. As a practitioner, it still feels to me like we are adding various rooms onto a house we love, rather than creating a new, elegant and coherent structure. We need to make sure there’s enough flexibility and clarity about the role of financial stability in our monetary policy framework. We need to better understand how macroprudential policies – such as mortgage insurance rules – that are aimed at promoting financial stability interact with monetary policy. Above all, our experience of these past few years reminds us that, as economists, there is a great deal that we just do not know. Our models are simple abstractions, and the notion of uncertainty that we build into them is usually of the benign, white-noise type that policymakers can generally ignore. I would argue, rather, that the uncertainty that central bankers face is truly fundamental – Knightian in nature and scope – and we run the risk of making major policy errors if we simply assume that uncertainty away. This necessarily transforms monetary policy-making from something akin to reverse engineering into an exercise in risk management. Known unknowns So, let me now touch on some of the “known unknowns” that are on my mind, speaking as a practitioner of monetary policy – ideas for further research, if you will. First, there is the globalization of production, by which I mean the optimal geographic distribution of production chains by companies. We see research and development in one country, manufacturing of components in several other countries, and final assembly in yet another. This phenomenon is well documented, but its effect on some of the things we hold dear is not well understood. For example, there is evidence that fluctuations in global inflation account for a large and growing share of the variation in inflation in individual economies. How does this affect our ability to target domestic inflation? And how does the international rearrangement of manufacturing processes affect the way that monetary policy influences the domestic economy? Second, there has traditionally been a reasonably well-understood role for exchange rate fluctuations in monetary policy actions, and in the equilibration of the economy in response to shocks. Canada, in particular, remains committed to a flexible exchange rate regime. But a growing share of global output is now produced in economies with fixed or heavily managed exchange rates; plus, as I said, companies have spread their supply chains across multiple countries with multiple exchange rates. How does all this affect the transmission of monetary policy actions to the economy? Third, there are interesting questions around the impact of changing income distribution on the monetary policy transmission mechanism. Globally, we are in the midst of two dramatic waves: a demographic wave, as large numbers of workers in their peak earning years retire; and a technological wave, which is producing structural adjustments in labour markets, especially in the middle of the income distribution. How do these forces affect the responsiveness of the economy to monetary policy, and our ability to maintain low and stable inflation? Fourth, our macroeconomic models are based on the so-called “representative firm” that reacts to policy changes by, for example, borrowing, hiring and investing more when interest BIS central bankers’ speeches rates are lowered, and less when they are raised. But we know that smaller firms behave very differently from large firms, and the credit channels they deal with are not the same at all. In our current situation, where so many firms have simply disappeared, we need to understand these processes well, because our ultimate recovery will depend on a rebuilding process involving high levels of new firm creation. These are just some of the things on my mind, and they arise just as the Bank prepares to renew its inflation-targeting agreement with the government, which is scheduled for 2016. The technical issues directly related to that agreement were laid out in a speech in Calgary in November by my colleague, Deputy Governor Agathe Côté, which I recommend to you. But it should be clear that the lessons of the recent crisis are colouring the research agenda. As Agathe Côté said in her speech, nothing is broken, and the bar for changes to the inflation-targeting agreement will be high. In spite of the financial stability issues I have raised today, inflation targeting has served us well, and we remain committed to the concept. As I said at the beginning of my remarks, however, there are lots of monetary policy rules with the same inflation outcome, each with different implications for the economy, and we need to understand these better within an agreed inflation-targeting regime. We have learned that the interest rates associated with 2 per cent inflation leave very little room to manoeuvre in response to large shocks. Furthermore, we know that the so-called neutral real interest rate will be lower in future, for demographic reasons in particular, and this will reduce our manoeuvring room even more. Together, this could mean a greater risk in the future of hitting the effective lower bound for interest rates for any given inflation target. We will need to consider the risks of any changes to the current flexible inflation-targeting regime, including any possible side effects on policy credibility, before we make any decisions. Conclusion Let me conclude with a few thoughts on our current situation. Since the onset of the crisis, central banks, including the Bank of Canada, have been reworking the way they balance risks to financial stability and inflation with their policies. In a discussion paper last year, I tried to detail how we apply this risk-management framework, using the experience of 2013 and the first half of 2014 as an illustration. But the events of the last six months have illustrated these points even more vividly. The Bank has been setting policy with a view to balancing the risks facing both the outlook for returning inflation sustainably to its target, and the risks to financial stability such as those posed by the indebtedness of Canadian households. The sudden drop in global oil prices has increased both risks. The oil-price shock is an important setback in our progress toward full capacity, full employment and stable inflation because it is a net negative for economic growth. And because lower oil prices mean lower Canadian income, the shock will worsen the debt-to-income ratio of Canadian households, thereby increasing financial stability risks. Our decision to lower the policy interest rate last month was intended to take out some insurance against both sets of risks. It gives us greater confidence that we can get back to full capacity and stable inflation by the end of 2016, instead of sometime in 2017, and it will cushion the decline in income and employment, as well as the rise in the debt-to-income ratio, that lower oil prices will bring. Using the term “insurance” underscores that we are in a very uncertain setting, and what we are trying to do is to manage the risks we face, not eliminate them – we are not in a position to engineer the perfect outcome. The negative effects of lower oil prices hit the economy right away, and the various positives – more exports because of a stronger U.S. economy and a lower dollar, and more consumption spending as households spend less on fuel – will arrive only gradually, and are of uncertain size. Plus, the oil price shock itself is of uncertain BIS central bankers’ speeches size. So, the downside risk insurance from the interest rate cut buys us some time to see how the economy actually responds. As you can tell, it’s an exciting time to be a central banker. Monetary policy-making is evolving in real time and, as I have argued, is deserving of true reinvention. We need to develop a monetary policy framework that integrates inflation risks and financial stability risks, both statically and dynamically, and captures much more accurately the uncertainties we face – in short, a true synthesis that takes full account of the lessons of the past, both new and old. Let’s get to it. BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Canada-United Kingdom Chamber of Commerce, London, United Kingdom, 26 March 2015.
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Stephen S Poloz: Central bank credibility and policy normalization Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Canada-United Kingdom Chamber of Commerce, London, United Kingdom, 26 March 2015. * * * I would like to thank Don Coletti, Stephen Murchison, Eric Santor, Scott Kinnear and Jing Yang for their help in preparing this speech. Introduction I am happy to be in the City and to have the opportunity to speak with you this afternoon. You can feel the pulse of the global financial system here, and it feels a bit like an irregular heartbeat to me. The recovery from the Great Recession has been a long, drawn-out affair, with some countries emerging faster than others. Long-term interest rates are extremely low, well below central banks’ inflation targets. Financial market volatility has gone up across the board, as economies and policies diverge and the prospect of policy normalization becomes more real. Today, I would like to consider what this all means for central bank credibility, which is something we should all care about. Do very low long-term interest rates and recent increases in financial market volatility represent an erosion of central bank credibility? It probably won’t come as a surprise to you that I would say no. Central banks are doing their jobs in a very challenging setting. In my time today, I will talk about what we can learn from low interest rates and increasing financial market volatility, as well as what we can expect as we go through the process of normalizing monetary policy. Long-term interest rates and credibility Let’s begin by looking at the extremely low borrowing costs we see in many economies. Consider, for example, the return that one would receive on a 10-year bond issued by any G-7 government and held until it matured. Investors would be accepting an annual return that would be below the central bank’s inflation target – in some cases, well below. What is it telling us when investors are willing to receive such low returns? Central bank policy frameworks may differ, but the concept of inflation control is at the heart of monetary policy in most economies. Are low yields an indication that investors think we will be unable to bring inflation back up to its target? To help answer this question, let’s look at the Canadian data. In a recent paper, Bank of Canada economists Bruno Feunou and Jean-Sébastien Fontaine used a term structure model to decompose the yield on a 10-year Government of Canada bond into three components: long-term inflation expectations, expectations of real short-term interest rates and the term premium. Our analysis shows that Canadian long-term inflation expectations have stayed quite close to our 2 per cent target since the onset of the financial crisis. This message is corroborated by other methods we have of measuring longer-term inflation expectations. These include surveys of professional forecasters and the break-even inflation rate that is based on comparing nominal and Real Return Bonds. Let me pause here to stress a point. Why are inflation expectations so important? It’s because well-anchored expectations help promote stability in inflation and output as well as the financial system. Solid inflation expectations also give central banks more leeway in responding to temporary shocks, such as changes in energy prices or movements in the exchange rate. BIS central bankers’ speeches Evidence shows that, for the most part, central banks have been doing well at keeping expectations anchored in a very challenging environment. Measured in this way, it is clear to me that our credibility is intact. But we won’t take false comfort. Vigilance is required, because if long-term expectations shift away from the target, it can be very difficult to reanchor them. So, to understand why long-term interest rates are so low, we need to look at the two other components – expectations for real short-term interest rates, and the term premium. These components account for the drop in long-term bond yields that we have seen since the crisis. This is relevant to our topic because these components have also been heavily influenced by central banks as they worked to meet their inflation goals in the aftermath of the crisis. Let me make four points here. First, expectations for real short-term interest rates depend on the level of the real neutral rate of interest – the rate that will generate just enough savings to finance investment in the long run. The Bank of Canada’s Senior Deputy Governor, Carolyn Wilkins, gave a speech last year in which she outlined why we should expect to see a lower real neutral interest rate globally. The reasons include slowing labour force growth and productivity growth in developed economies, suggesting a drop in demand for investment, and a very strong supply of savings from many emerging economies. So we must start thinking about equilibrium interest rates from a lower starting point. Second, on top of these structural factors, we’ve seen central banks react to the financial crisis and subsequent Great Recession by aggressively lowering policy rates. Several central banks, including the Bank of Canada, also found themselves constrained by the effective lower bound on interest rates. By issuing forward guidance in various forms, we were able to reduce expectations for the future level of the policy rate. This added to the pressure on expectations for real short-term rates. Third, central bank actions and forward guidance have served to reduce uncertainty about short-term policy interest rates, thus reducing the term premium. Fourth, the quantitative easing programs employed by some central banks included purchases of long-dated bonds, reducing the yields on those bonds. There is strong evidence that those purchases have even pulled down yields in markets that did not have quantitative easing, such as Canada. To sum up, there are very good reasons why long-term interest rates are unusually low, but the de-anchoring of inflation expectations is not the central driver. Rather, low long-term interest rates reflect a combination of a declining neutral rate of interest and the actions being taken by central banks to foster stronger growth in pursuit of their inflation targets. Ultimately, inflation expectations, and the inflation outcomes that support them, are how a central bank’s performance should be judged. Financial market volatility and credibility But some would judge a central bank’s credibility against a wider range of criteria, including the level of financial market volatility. In recent months, measures of volatility have risen in a wide variety of asset classes and across a number of countries, in U.S. Treasuries, in exchange rates, and in the Standard & Poor’s 500, just to give a few examples. There are many factors contributing to this increase, and I won’t try to list them all. But I will mention four. First, the forces acting on the global economy are powerful and affecting many economies differently. The post-crisis headwinds to growth, including widespread deleveraging and lingering uncertainty about the future, have proved highly persistent. Furthermore, the sharp drop in oil prices is having a significant effect, positive for some economies and negative for others. This shock surprised everyone, and the fact that it is so large and happened so quickly means that many of us have had to work hard to fully grasp all of its implications. BIS central bankers’ speeches Several central banks around the world, including the Bank of Canada, reacted to this environment with policy announcements that weren’t fully anticipated by investors. Second, these forces are leading to a divergence in monetary policy paths among the big three central banks. The European Central Bank and the Bank of Japan are implementing quantitative easing while the Federal Reserve is beginning the process of normalizing its policy. This divergence is naturally leading to a significant adjustment in the outlook for interest rates and currencies, as well as higher volatility in bond and foreign exchange markets. A third contributor to financial market volatility is related to global regulatory reform. The Basel III and other reforms are clearly making the global financial system safer, and that is job one. But they have also reduced incentives for banks and some dealers to hold inventory, act as market-makers and provide a shock-absorber function in times when volatility is high. Fourth, financial market volatility has been compressed in recent years by the one-sided nature of our economic outlook. With many economies operating with excess capacity, economic growth remaining weak and deflation a real threat in some economies, interest rates have been expected to stay very low for a very long time. This expectation was reinforced by forward guidance and other unconventional policies of central banks. But those expectations are starting to shift. The global recovery, although uneven and fragile, is progressing, and we are approaching a transition phase – taking the first steps on a path toward normalization, if you will. Eventually, the global headwinds will dissipate and central banks will be able to transition away from unconventional policies and return to more conventional ways of conducting monetary policy. This will mean a return to two-sided risks, where interest rates could rise or fall depending on how economies evolve. During this transition toward normal, more financial volatility is to be expected. To me, these seem to be legitimate reasons to expect higher financial market volatility today. And is the volatility we’re seeing now abnormally high? No. While market volatility has risen recently, it has done so from historically very low levels. It has begun to return closer to historical averages, not abnormal levels. So, is this increase in volatility actually a negative development? No. Above all, volatility relates to unexpected economic developments to which central banks will necessarily respond in order to fulfill their mandates. When shocks to the economy occur, whether positive or negative, higher financial market volatility is a natural consequence, an integral part of the economy’s equilibration process. Such financial volatility is neither inherently bad nor good. And if it reflects the emerging possibility that the one-sided outlook we have experienced for several years is finally becoming more balanced, then that is unambiguously good news. Getting back to normal Still, as we begin to work through the process of getting back to normal, the question remains: if explicit forward guidance can suppress financial market volatility, why not keep using it? In this context, what I mean by forward guidance is explicit statements around the future path of interest rates. Central banks inevitably talk about the future, and any such statement can be construed as a form of guidance for markets. All such forms have their uses, in the right context. But I reserve the term “forward guidance” to mean specific comments, or conditional commitments, around interest rates. There’s absolutely no question that forward guidance is a valuable part of the central bank tool kit. It has clearly been helpful in Canada and elsewhere. But as I said in a paper published last year, we at the Bank of Canada believe that statements to explicitly guide BIS central bankers’ speeches market expectations about the future path of interest rates are best reserved for extraordinary times, such as when policy rates are at the effective lower bound, or during periods of market stress. Keeping forward guidance in reserve ensures that it will have a greater impact when it is deployed. Otherwise, it becomes addictive and loses some of its impact – in short, forward guidance is not a free lunch, it comes with costs. Let me elaborate by stressing some of the points I made in that paper. Forward guidance works by taking some potential actions by the central bank off the table. A commitment not to raise interest rates for a given period, or until certain economic conditions are met, can flatten the yield curve and add stimulus to the economy. But in doing so, the commitment creates a skewed bet for investors. Volatility falls, for the time being, as market participants naturally position themselves around this bet, often using significant leverage to do so. So, what happens when circumstances change, as they inevitably do? What happens when investors start to consider the possibility that the guidance will change? The positions that are stacked around the central bank’s guidance unwind, and all that suppressed volatility suddenly resurfaces in financial markets, often to levels that surpass historical averages. That’s when we pay the price of forward guidance. To be sure, when the policy rate is at the effective lower bound, the benefits of forward guidance can easily outweigh the costs. At other times, the costs loom larger. Indeed, in normal times, when economic and financial risks are clearly two-way, there is a very basic law of economics at work. Volatility happens. It is a force of nature. Economists call this underlying volatility “shocks” – unexplained shifts in consumer demand or business behaviour, or oil-price shocks, or shocks from foreign economies, and, yes, financial market shocks. This volatility must go somewhere in the economy. Central banks target inflation, which means stabilizing inflation and economic growth, not interest rates. Pursuing that mandate means that financial markets carry more of the natural volatility that arises. To make this point in its most extreme form, consider how a hypothetical, all-seeing central bank would behave. That central bank would anticipate all shocks to the economy and move interest rates up and down to offset them, so inflation would always stay right on target. Looking at the data afterward, we might think that all the interest rate and financial market volatility was unnecessary, because inflation was on target the whole time. In other words, perfect policy making might look silly, simply because people cannot see the underlying shocks – but the financial market volatility would be a natural consequence of the central bank’s efforts to achieve its mandate. Of course, we haven’t been in normal times for quite a while. We are just taking the first tentative steps toward normalization, and the road won’t always be smooth, as our recent experience in Canada illustrates. Late last year, we saw encouraging signs that the economic recovery was broadening. Stronger exports had started to be reflected in greater business investment. However, as we approached our January decision on interest rates, we had to consider the unexpected plunge in global oil prices. Given the importance of oil to our economy, this shock represented a significant downside risk to our projected inflation profile. It also posed a risk to financial stability through the reduction in income that it implied. Because lower oil prices mean lower Canadian income, the shock would worsen the debt-toincome ratio of Canadian households, even if no new borrowing occurred. We thought in January that it would be best to act sooner rather than later, given the magnitude of the shock and the immediacy of its likely effects. Indeed, oil prices were still falling, and to levels below the assumptions built into our forecast. Accordingly, we took out some insurance in the form of a 25-basis-point cut in interest rates. The reaction to this cut across the yield curve and in the exchange rate would help to cushion the blow to the economy from the oil-price decline, bringing us back sooner to full capacity and sustainable 2 per cent inflation. It would also help mitigate the rise in the debt-to-income ratio by reducing the drop in income, although debt levels could rise at the margin. BIS central bankers’ speeches We knew that financial markets would be surprised by the move in January, and we generally prefer to avoid surprises. But we will do what is necessary to fulfill our inflationtargeting mandate. Over the following weeks, we saw inflation decline as expected, and output expand in line with our projection. We saw financial conditions ease, and oil prices stabilize in a range reasonably close to our January projection. This made us feel increasingly comfortable with the amount of insurance we had already taken out, which led to the decision to keep rates unchanged earlier this month. The negative effects of lower oil prices are beginning to appear; the positives will take longer to emerge. So we need to watch these competing forces play out in the economy, and the January rate cut has bought us some time to monitor the situation as it evolves. Some have characterized this as a move to “data dependency.” I have to say I find this a bit strange. Data are always crucial in determining how the economy is progressing. Even in extraordinary times, central banks depend on data to help them evaluate how the economy is performing relative to expectations. As our economy gradually gets back to normal, we will continue to speak with business leaders to get their perspectives. We will continue to watch the data closely, as we always do, and see how the numbers evolve relative to our forecasts. And we will look to market participants to keep watch on the same data, and form their own opinions about what they mean. Our communications focus on explaining how we expect the economy to unfold and being transparent about the risks that the central bank is weighing. All else equal, this should help reduce the chances of surprising markets. Still, in normal circumstances, it’s natural that there would be volatility as economic surprises occur. But, we think it best to have this volatility reflected in prices in informed, well-functioning financial markets, rather than be artificially suppressed by forward guidance. Conclusion Allow me to conclude. As we have seen, well-anchored inflation expectations reflect the unwavering pursuit of our inflation goals. They show that market participants continue to believe both in our commitment and our ability to return inflation to its target. Unconventional monetary policies have played a key role, in Canada and elsewhere, in promoting growth and helping to meet our inflation goals. As the global economy shakes off the Great Recession, and the era of unconventional policies comes to an end, a return to ultra-low levels of financial market volatility is unlikely. Bouts of increased volatility can be expected as guidance-influenced positions are unwound and as markets react to shocks. As we go through the normalization process, this represents the natural reaction of financial markets to economic uncertainty and a return to a normal trading environment – not an erosion of central bank credibility. The Bank of Canada will continue to pursue and fulfill our inflation-targeting mandate. We will continue to follow the policies necessary to ensure a timely return of inflation to target while being mindful of financial stability considerations. This process takes place in an uncertain world where shocks happen daily, behaviour shifts repeatedly, and our analytical tools and models can offer only rules of thumb. In that sense, monetary policy is a very imprecise business – less like engineering and more like risk management. Ultimately, our credibility will hinge on how well we meet our mandate over extended periods of time. I’m confident that we will continue to get the job done. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 15 April 2015.
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Stephen S Poloz: Release of the Monetary Policy Report Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 15 April 2015. * * * Good morning. Carolyn and I are happy to be here to answer your questions about today’s interest rate announcement and our latest Monetary Policy Report (MPR). Let me begin with a few remarks around the issues that were most important to the Governing Council’s deliberations. I’ll start with the global context. The plunge in oil prices was due mostly to strong supply growth, but a softening in demand growth also contributed. A wide range of other commodity prices have declined further this year, also suggesting a softer world economy. In this context, we have seen many central banks ease policy this year, ourselves included. This widespread easing, coupled with the positive implications of lower energy prices for world growth, leads us to the conclusion that the global economy will pick up through the year. Increased economic divergence is prompting divergent monetary policies as well, and is delivering more exchange-rate volatility and, on net, more strength in the U.S. dollar. Turning to Canada, as we stated in the January MPR, although lower oil prices would have both upside and downside effects on Canada, the net impact would be negative. The negative effects would be immediate and seemed quite certain, whereas the positive effects would be more gradual and less certain. Therefore, we faced a risk that our return to full capacity and stable 2 per cent inflation would be delayed significantly. Accordingly, in January we took out some insurance against that risk, in the form of a 25-basis-point reduction in the policy interest rate. Our cut led to lower rates across our entire yield curve and a lower Canadian dollar. Meanwhile, oil prices stabilized and recovered to levels around our January forecast assumptions. And, as we monitored the data, we saw that some of the effects of lower oil prices were already being felt during the fourth quarter of 2014. The updated forecast in today’s MPR suggests that the economy saw no growth in the first quarter. I want to emphasize that policy does not hinge on decimal points – we always know we are dealing with a range of possible outcomes. Interpretation of the recent data is complicated by the slowdown in the U.S. in the same quarter, which no doubt was partly due to severe weather and a port strike in Los Angeles. We had some unusual weather ourselves. However, our best judgement is that the data we have received so far remain consistent with the view that the impact of the oil price shock is proving to be faster than initially expected, not larger. Outside of the energy sector, other areas of the economy appear to be doing well. In particular, the segments of non-energy exports that we have been expecting to lead the recovery have been doing so, and we expect this trend to be buttressed by stronger U.S. growth and the lower Canadian dollar. Our Business Outlook Survey indicates that capacity constraints are beginning to emerge for exporters, which is promising for new investment. And, although we still have material slack in our labour market, the market’s fundamentals have begun to improve. Even so, companies remain cautious about new investment and hiring intentions. Weighing these various forces acting on the economy, we are anticipating a rebound in growth in the second quarter, and a move to above-trend growth thereafter, for annual growth of 1.9 per cent this year. This projected growth profile gets us back on track to use up our excess capacity around the end of 2016, at which time inflation will settle sustainably on BIS central bankers’ speeches 2 per cent. We see the risks around this projection as roughly balanced, but they will be reassessed continuously as new data become available. The main risk is the size and duration of the negative impact of the oil shock, weighed against the positive forces that are building in the non-energy export sector. Our outlook is for the positives to begin to reassert themselves during the second quarter, and to do so clearly in the second half of the year. The interest rate cut of January and the lower Canadian dollar are working to speed up the transition. To give just one example, exporting companies with existing contracts denominated in U.S. dollars are seeing an immediate 8 per cent increase in Canadian-dollar cash flow, and will be able to compete more aggressively for future sales. Inflation as measured by total CPI today is running at about 1 per cent, well below our 2 per cent target. This is largely due to the drop in gasoline prices, a temporary effect. But total CPI inflation would be even lower than 1 per cent, in fact quite close to zero, were it not for exchange-rate effects, which are boosting total inflation by 0.6 to 0.7 percentage points, and some additional one-time factors. Core inflation is running at about 2 per cent, but it is also being boosted by exchange-rate effects and a couple of other one-time factors. Because monetary policy takes up to two years to have its full effect on inflation, responding to every fluctuation in prices would be counter-productive. Therefore, we generally look through inflation variations that, in our judgement, will prove temporary. These judgements constitute a very important part of our deliberations. Presently, we are looking through the effects of the drop in oil prices, the effects of the recent depreciation of the Canadian dollar, and the one-time effects of fluctuations in meat and telecommunications prices. This is why we refer to “underlying inflation”, which estimates and excludes what we judge to be temporary factors, and is driven mainly by the changes in the degree of excess capacity in the economy. In our projection, total inflation, core inflation and underlying inflation all converge on the same level once temporary factors have dissipated. Meanwhile, the issue of financial stability risks remains front-and-centre in our deliberations. These risks are evolving in line with our expectations. The level of indebtedness, as measured by the debt-to-disposable income ratio, continues to rise. It is likely to rise further as the decline in gross national income, due to the halving of oil prices, works its way through the system. On the surface, lower interest rates would be expected to promote more borrowing, which would increase this vulnerability. However, in the near term, lower borrowing rates will actually mitigate this risk, by reducing payments for mortgage holders and giving us more economic growth and employment gains. We believe that the best contribution the Bank can make to easing financial stability risks through time is to help the economy return to full capacity and stable inflation sooner, rather than later. With that, Carolyn and I would be happy to take your questions. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, before the House of Commons Standing Committee on Finance, Ottawa, Ontario, 28 April 2015.
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Stephen S Poloz: Opening statement before the House of Commons Standing Committee on Finance Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, before the House of Commons Standing Committee on Finance, Ottawa, Ontario, 28 April 2015. * * * Good morning, Mr. Chairman and committee members. Carolyn and I are happy to be here for one of our twice-yearly meetings on our Monetary Policy Report (MPR). Today we will outline for you the Bank’s latest economic outlook, published in our MPR on 15 April. In this volatile and uncertain environment, it is helpful to maintain a historical perspective. When we appeared before this committee a year ago, the price of Brent crude oil was at $100 per barrel. It had risen steadily for a decade, from $25 in 2002 to a peak of just over $110 in 2012. By November, when we last met with you, oil prices had fallen to what was then their lowest level in four years. The average price of Brent was $90 per barrel. It was clear to us that while lower oil prices would benefit consumers, the net impact on the economy would be negative. Lower oil prices would reduce Canada’s terms of trade and domestic income and have a material impact on investment, activity in the oil sector, and the associated manufacturing supply chain. All of that happened quite quickly over the next two months. By January, Brent prices had dropped to an average of $60. Oil prices are an important component of Canada’s terms of trade and one of the key drivers of movements in the Canadian dollar. As oil prices rose over the 2002–12 period, so did the value of the dollar, increasing from around 63 cents to above parity. Now, the fall in oil prices has set in motion complex dynamics, including sectoral and regional adjustments, which will take time to work their way through the economy. The negative effects of lower oil prices hit some sectors of the economy right away. For example, the impact of lower prices on income and wealth has already led to a fall in household spending. The various positives – more exports because of a stronger U.S. economy and a lower Canadian dollar, and more consumption spending as households spend less on fuel – will arrive only gradually, and are of uncertain size. Therefore, in January we faced a risk that returning the Canadian economy to full capacity and stable 2 per cent inflation would be delayed significantly. Accordingly, we took out some insurance against that risk, in the form of a 25-basis-point reduction in the policy interest rate. Our interest rate cut occurred in the context of widespread easing in financial conditions around the globe. No fewer than 25 central banks eased their monetary policies in the early months of 2015. All of this monetary policy easing led to lower rates across the entire yield curve. What was behind this easing? Many central banks were adding stimulus in response to persistent economic slack and below-target inflation. This easing, coupled with the positive implications of lower energy prices for world growth, should help the global economy pick up through the year. The Bank expects global economic growth to strengthen and average about 3 1/2 per cent over the 2015–17 period. Here in Canada we saw that some of the effects of lower oil prices, such as the lower household spending I mentioned earlier, were clearly being felt in late 2014 and early 2015. Our updated forecast in the April MPR suggests that the Canadian economy saw no growth in the first quarter. While the impact of the oil price shock is happening faster than initially expected, it does not appear to be larger than we anticipated in January. BIS central bankers’ speeches Outside of the energy sector, other areas of the economy appear to be doing well. The segments of non-energy exports that we expected to lead the recovery are doing so, and we expect this trend to be buttressed by stronger U.S. growth and the lower Canadian dollar. The results of our Business Outlook Survey suggest that capacity constraints are beginning to emerge for exporters, which is promising for new investment. And, although we still have material slack in our labour market, the market’s fundamentals have begun to improve. Even so, companies remain cautious about new investment and hiring intentions. Weighing these various forces acting on the economy, we anticipate a partial rebound in growth in the second quarter, and a move to above-trend growth thereafter, for annual growth of 1.9 per cent this year. This projected growth profile gets us back on track to absorb our excess capacity around the end of 2016, at which time inflation will settle sustainably at 2 per cent. We see the risks around this projection as roughly balanced, but they will be reassessed continuously as new data become available. The main risk to our outlook is the size and duration of the negative impact of the oil shock, weighed against the positive forces that are building in the non-energy sector. Our outlook is for the positives to begin to reassert themselves during the second quarter, and to do so clearly in the second half of the year. The interest rate cut in January and the lower Canadian dollar are working to speed up the transition. Inflation, as measured by total CPI, is running at about 1 per cent, well below our 2 per cent target. This is largely due to the drop in gasoline prices, a temporary effect. Total CPI inflation would be quite close to zero were it not for exchange-rate effects and some additional one-time factors. Core inflation is a little over 2 per cent, but it is also being boosted by exchange-rate effects and other one-time factors. In our projection, total inflation and core inflation converge on 2 per cent as these temporary factors dissipate and the economy reaches full capacity, around the end of 2016. Meanwhile, financial stability risks remain front-and-centre in our deliberations. These risks are evolving in line with our expectations. The level of indebtedness, as measured by the ratio of debt-to-disposable income, continues to edge higher. It is likely to rise further as the decline in gross national income caused by the drop in oil prices works its way through the system. On the surface, lower interest rates would be expected to promote more borrowing, which would increase this vulnerability. However, in the near term, lower borrowing rates will actually mitigate this risk, by reducing payments for mortgage holders and giving us more economic growth and employment gains. We believe that the best contribution the Bank can make to lowering financial stability risks through time is to help the economy return to full capacity and stable inflation sooner, rather than later. With that, Carolyn and I would be happy to take your questions. BIS central bankers’ speeches
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Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, to the Chambre de commerce du Montréal métropolitain, Montréal, Quebec, 5 May 2015.
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Carolyn Wilkins: Liquid markets for a solid economy Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, to the Chambre de commerce du Montréal métropolitain, Montréal, Quebec, 5 May 2015. * * * I’d like to thank Alexandra Lai, Césaire Meh, Chris Graham and Jing Yang for their help in preparing this speech. Introduction Good afternoon. It’s a real pleasure to be here in Montréal, where I have family roots. I want to talk today about an important financial force that affects all of us who invest and borrow. I’m talking about financial liquidity, in all of its forms. Right now, liquidity is going through some important changes. We are all affected by liquidity, whether we realize it or not. If you are a business person, you need funding liquidity, which means that you have reliable access to financing on reasonable terms. If you invest in the stock market or in corporate bonds, you need market liquidity so you can buy or sell assets quickly, at predictable prices. The same is true if you are a saver through certain kinds of mutual funds that promise you access to your savings when you want them. As a central banker, I want the economy to have the right level of liquidity available at the right price so the financial system can keep working smoothly for businesses and households and the Bank’s monetary policy actions work the way they are supposed to, in order to meet our inflation target. 1 Today I’ll talk about what has been happening to liquidity in the financial system. I’ll start by looking back at the recent financial crisis and the lessons we learned. Then I’ll review the reforms that are being implemented in Canada and elsewhere and talk about how the financial system is evolving and what all this may mean for you. Finally, I’ll discuss the next steps we’re planning at the Bank of Canada to promote a smoothly functioning and safe financial system. The crisis and its lessons The seeds of the crisis were sown in a time when liquidity seemed to be everywhere. Think back to 2006, when it was relatively easy for businesses to get loans and households to take out mortgages. Financial institutions, particularly in the United States, were so eager to boost profits by extending credit that they started bundling mortgages and securitizing them. These securities satisfied the demand for so-called safe assets that gave a higher return. Memories become more painful as we move into 2007. Canada had a sound financial system, but we still ran into trouble. During the summer, the more-than-$32 billion market for Canadian non-bank asset-backed commercial paper (ABCP) froze. Companies that relied on this market for funding were hurt, along with investors, including some of Quebec’s largest firms, which suddenly had no market for the paper. While there were some doubts about the assets behind the paper, the shortage of liquidity undoubtedly worsened the crisis and spread it to other markets. A lack of transparency about the assets and a poorly designed liquidity backstop didn’t help. Ironically, even though some said that ABCP was backed by just about anything, the underlying assets in the Canadian D. W. Diamond, and R. Rajan, “Liquidity Shortages and Banking Crises,” Journal of Finance, 60, no. 2 (2005): 615–47. BIS central bankers’ speeches paper ultimately turned out to be relatively sound, and the losses felt by the investors were largely the result of the market freeze. The affected companies, the provincial and federal governments, and the Bank of Canada worked hard to negotiate the Montreal Accord. This included a standstill agreement and rescheduling of payments, along with protection for smaller investors. I chose this example because we’re in Montréal, but there are plenty more that show that liquidity can evaporate quickly for reasons that aren’t immediately obvious. 2 But it was clear in 2008 with Bear Stearns and Lehman Brothers that, when liquidity disappears, everybody can feel the consequences, and they are very expensive. 3 The fallout from the crisis because of credit and liquidity issues is estimated to have cost the global economy more than US$10 trillion in lost output. The response A lot has been done, both in Canada and globally, to respond to the lessons taught by the crisis. The goal is to strengthen the world’s financial system so that it functions well, reducing the costs and chances of any future crisis. 4 It’s also to make sure taxpayers won’t be on the hook for the cost of any future turmoil. Let me mention some of the most important reforms. Internationally, policy-makers gathered at the Basel Committee on Banking Supervision to establish new regulatory standards. The Basel III package, as it’s called, is perhaps best known for its regulations that determine how much capital banks need to have, while taking into account how risky their assets are, and how much leverage they are allowed to take on. Globally, banks have doubled the amount of Tier 1 capital they hold, and Canada’s banks have been at the forefront of this effort. Equally important are the standards that make banks more resilient from a liquidity perspective. I was pleased to be one of Canada’s representatives in Basel and to chair the working group on liquidity. Two new rules are being implemented. The Liquidity Coverage Ratio means that banks will have enough high-quality liquid assets available to meet their needs in the case of a stress scenario that lasts 30 days, thereby ensuring that they can continue to operate when access to funding may be impaired. The other new standard is the Net Stable Funding Ratio, which will work to reduce banks’ over-reliance on short-term funding for longer-term assets. 5 These rules make it less likely that banks will face a funding shortfall, which could lead to them overly restrict funding to companies and households. In addition to Basel III, the Financial Stability Board (FSB) has been leading work to ensure that banks have crisis-management frameworks in place should they come under serious stress that threatens their viability. These include recovery frameworks, which would allow banks to shore up capital, restore confidence and get funding liquidity flowing again. The FSB has also led work on so-called resolution frameworks to be used if a bank’s recovery M. K. Brunnermeier, “Deciphering the Liquidity and Credit Crunch 2007–2008,” Journal of Economic Perspectives 23, no. 1 (2009): 77–100; C. Gauthier and M. Souissi, “Understanding Systemic Risk in the Banking Sector: A MacroFinancial Risk Assessment Framework,” Bank of Canada Review (Spring 2012): 29–38. F. Allen and D. Gale, “Financial Fragility, Liquidity, and Asset Prices,” Journal of the European Economic Association 2, no. 6 (2004):1015–48. T. Ahnert, “Rollover Risk, Liquidity and Macroprudential Regulation,” Working Paper No. 2014–23, Bank of Canada, 2014. Basel Committee on Banking Supervision (BCBS), “Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools,” January 2013; BCBS, “Basel III: The Net Stable Funding Ratio,” October 2014; T. Gomes and C. Wilkins, “The Basel III Liquidity Standards: An Update,” Bank of Canada Financial System Review (June 2013): 37–43. BIS central bankers’ speeches actions aren’t enough to get the bank back on its feet. These will allow national authorities to either maintain the bank’s critical operations and eventually return it to viability, or wind up the institution at minimal cost to taxpayers. The final response I’ll mention has to do with ensuring that the most important markets for funding liquidity, such as the repo market for government securities, can keep operating in times of stress. As we saw with Lehman Brothers, when a financial institution comes under suspicion, others may avoid trading with it. When a bank can’t get funding, that’s when it may call in its loans or cut its lines of credit, and companies feel the pain directly. One way of increasing resilience in financial markets, including repo markets, is to establish a central counterparty (CCP) service. Canada has developed such a service here in Montréal. 6 The Bank of Canada has designated it as systemically important. That means we oversee it, in co-operation with the Autorité des marchés financiers, the Ontario Securities Commission and the British Columbia Securities Commission. The Bank has authority to oversee all systemically important financial market infrastructures. The implications This response by global and national authorities has meant a lot of change. Taken as a whole, the reforms make the world’s financial system safer. However, that safety isn’t free. Like all regulations, the Basel rules on capital and liquidity come with costs, both direct and indirect. For example, financial institutions have to make decisions about how to best allocate their capital. The more assets they hold, and the riskier those assets are, the greater the capital charges they incur. Those extra costs will either reduce profits or be passed on to customers, perhaps in the form of somewhat higher interest rates or stricter conditions on loans, or a reduction in some business lines altogether. The reforms are also affecting market liquidity in a number of ways. 7 We’ve seen some financial institutions that traditionally act as market-makers for bond trading cut back on this activity. In the United States, dealer inventories of corporate bonds have fallen to less than half their pre-crisis levels. 8 At the same time, there is more demand for safe assets. The Basel rules on capital and liquidity are increasing the demand for high-quality assets such as government bonds. It’s not all about regulation, though. Those same bonds are being bought and held by many institutions for separate reasons. Certain central banks are stimulating their economies by buying assets. Some central banks and sovereign wealth funds are accumulating reserves. The International Monetary Fund estimates that the world’s official international reserves quadrupled to US$11 trillion in the 10 years ending in 2013. These purchases are reducing the pool of bonds available for trading and for use as collateral. Further, financial institutions have become more risk-averse in general, going beyond regulatory requirements to build up cushions of high-quality assets. We’re hearing a lot of commentary about how liquidity may be diminishing in secondary bond markets, especially for corporate bonds. We see that the average size of a transaction has dropped and turnover rates are down from pre-crisis levels. Bid-ask spreads remain wider than they were in 2006. 9 The service is run by the Canadian Derivatives Clearing Corporation. It also clears derivatives contracts traded on the Montréal Exchange and some over-the-counter derivatives. Committee on the Global Financial System, “Market-Making and Proprietary Trading: Industry Trends, Drivers and Policy Implications,” CGFS Papers No. 52, November 2014. I. Fender and U. Lewrick, “Shifting Tides – Market Liquidity and Market-Making in Fixed Income Instruments,” BIS Quarterly Review (March 2015): 97–109. Ibid. BIS central bankers’ speeches In sovereign bond markets, there are mixed signals. 10 On the one hand, bid-ask spreads in the United States and Europe are very close to what they were before the crisis. On the other hand, in some cases average transaction sizes may be smaller than they were, and the market may not be as deep. Liquidity is also influenced by the players in the market. The shadow banking system is growing in size and influence”. 11 Here, I’m referring to institutions such as hedge funds that intermediate credit but operate outside of the regular banking system. Despite the ominoussounding name, shadow banks have an important, positive role to play in the economy. Their influence is growing, along with the amount of assets they have to manage. They have also introduced a number of new financial products and innovations. While Canada’s shadow banking sector is relatively small compared with those of other countries, we are still closely involved in international efforts to monitor it. 12 The Financial Stability Board has been coordinating these efforts and publishes regular monitoring reports. Canada is also an active participant in the FSB’s thematic peer-review of shadow banking, and I’m leading the team that will conduct it. Let me give you an example of the kind of risk that’s worth watching. At the global level, institutional funds are growing. This includes funds, such as open-ended mutual funds and some exchange-traded funds (ETFs), where investors can sell or redeem their investment on short notice. This can be the case even if the assets held by the funds are relatively illiquid. The salient question is what happens if many funds see large numbers of investors asking to redeem at the same time. The worry is that fund managers may not have enough cash holdings and may be forced to incur large losses as they sell assets to cover redemptions. 13 There are stress-test results that suggest that fund managers are holding enough cash to cover all but the largest redemption shocks. 14 But it’s far from clear that all investors and savers appreciate the liquidity and redemption risks involved in some funds. I’m not trying to tar all these funds with the same brush, but I would say everyone should be aware of all the risks involved in investing, including liquidity risks. The bottom line on the reform package is that the risks of financial transactions will be priced more appropriately. This will make funding and market liquidity marginally more expensive. But weighed against the cost of another crisis, it’s a small price to pay. 15 The backstop The Bank of Canada has a role to play in promoting the stability and resilience of core funding markets, in normal times as well as during times of extraordinary market stress. Today, we’re publishing two consultation papers that spell out how we intend to adjust our Ibid. Z. Pozsar, “A Macro View of Shadow Banking: Do T-Bill Shortages Pose a New Triffin Dilemma?” in Is U.S. Government Debt Different? edited by F. Allen et al. (Philadelphia, PA: FIC Press, 2012), 35–44. T. Gravelle, T. Grieder and S. Lavoie, “Monitoring and Assessing Risks in Canada’s Shadow Banking Sector,” Bank of Canada Financial System Review (June 2013): 55–63. M. Feroli, A. K. Kashyap, K. L. Schoenholtz, and H. S. Shin, “Market Tantrums and Monetary Policy,” Chicago Booth Research Paper No. 14–09, 2014. Morgan Stanley and Oliver Wyman Blue Paper, Wholesale & Investment Banking Outlook, 19 March 2015. Financial Stability Board and Basel Committee on Banking Supervision, “Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements,” Final Report of the Macroeconomic Assessment Group, December 2010, available at http://www.bis.org/publ/othp12.pdf; Bank of Canada, “Strengthening International Capital and Liquidity Standards: A Macroeconomic Impact Assessment for Canada,” Special report, August 2010, available at http://www.bankofcanada.ca/wpcontent/uploads/2010/09/report.pdf. BIS central bankers’ speeches financial market operations and emergency lending policies. These two papers can be found on our website. 16 My colleague, Deputy Governor Lynn Patterson, will talk in detail about initiatives relating to the Bank’s market operations in a speech in Vancouver next week. Let me walk you through the highlights, while stressing that you should infer nothing from these proposals for the current or future stance of monetary policy. First, the Bank is proposing to reduce the amount of benchmark government bonds we buy at government bond auctions for our own balance sheet. This will help liquidity by increasing the amount of such newly issued securities that will be available to other buyers. For its part, the Bank will buy some of the assets we need in the secondary market for government bonds. Second, we are exploring changes to our securities-lending program. This would assist primary dealers that contribute to market liquidity but that need to borrow securities, while still encouraging the market to clear itself. Finally, we intend to set up a regular program of term repo operations that will not only help us manage our balance sheet, but also give us timely insight about liquidity conditions in short-term funding markets. These steps will all help markets in normal times. But we need to be ready for when times aren’t so normal. We’re using this period of relative calm to sharpen our tools that could be used in any future periods of stress. During the crisis, the Bank set up a temporary term repo facility that reduced short-term funding pressure for primary dealers, which improved market conditions. 17 At its largest, the facility grew to $42 billion. What we are now proposing, in addition to the regular term repo program I just mentioned, is a Contingent Term Repo Facility that we can activate at our discretion when we see severe liquidity problems that are market-wide. The facility would offer liquidity for terms of up to one month that could be made available to primary dealers and, in some circumstances, other institutions if we judge it necessary for the stability of the financial system. In addition to this facility to deal with extraordinary market-wide stress, we are proposing changes to how we deal with liquidity issues at individual institutions. This is our traditional role as lender of last resort. What this role means is that we act as a backstop to make sure that a liquidity shortage in one place doesn’t turn into widespread stress for the whole system. We haven’t done a comprehensive review of this role since 2004, and it’s time to take the lessons of the crisis on board. Our Emergency Lending Assistance (ELA) was traditionally meant for financial institutions that were judged to be still solvent, but unable to access liquidity. In an emergency situation, it can be very difficult to distinguish insolvency from illiquidity. So we will now restrict ELA to those institutions that have in place the credible frameworks for recovery and resolution that I spoke of earlier. This will ensure that any lending will be part of a coordinated effort taken by the institution and the authorities, as needed, to bring a distressed institution back to viability. And if it can’t recover on its own, the authorities can do what is needed to restructure or liquidate the business while maintaining any functions that are critical to the financial system and without exposing taxpayers to loss. We are also clarifying that we would, under certain conditions, provide emergency lending to provincial institutions such as caisses populaires or credit unions and their centrals. Because these institutions can get liquidity support from their provincial centrals, we would limit ELA to cases that have implications for the Canadian financial system. As well, we are prepared to provide emergency lending to address liquidity problems at key Canadian market Available at https://en.ews.staging.boc.ets.net/2015/05/public-consultations-bank-canada-framework-financialmarket-operations/. E. Enenajor, A. Sebastian and J. Witmer, “An Assessment of the Bank of Canada’s Term PRA Facility,” The North American Journal of Economics and Finance 23, no. 1 (2012): 123–43; Bank of Canada Working Paper No. 2010–20. BIS central bankers’ speeches infrastructures that are overseen by the Bank. This is essential because infrastructures such as CCPs are becoming more important. Finally, we are adjusting the range of collateral we would accept as a last resort for emergency loans. This collateral could include mortgages, which would give a stressed institution more capacity to accept ELA in an emergency. To be clear, this would only occur after all other collateral had been exhausted. I should stress that these policies are for extremely rare occasions – the Bank hasn’t activated its ELA policy in roughly 30 years. And the guiding principles behind these changes are the same as those that led the international response to the crisis – we want to minimize the risk of a future systemic crisis while protecting taxpayers from bearing the cost of recovering or resolving a troubled financial institution. Conclusion A solid economy rests on reliable funding and market liquidity. We learned from the crisis that liquidity can be a fickle friend, and its absence can amplify financial distress. The reforms to date will make the financial system safer. They are designed to lower the risk profile of core financial institutions and to increase the resilience of funding and market liquidity in times of market stress. The transition is challenging market participants to adjust their business models to the new reality. I hope that you better understand the importance of liquidity so you can make appropriate financial decisions for you and your companies. The Bank of Canada will continue to promote the economic welfare of Canadians by supporting the stability and resilience of our financial system. We are adjusting our liquidity policies to contribute to the smooth functioning of the financial system in normal times. And, should another major bout of liquidity turmoil arise, we will be ready. If we all do our part, a more robust financial system will emerge, to the benefit of the people it ultimately serves: businesses and households who save and borrow. BIS central bankers’ speeches
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Remarks by Ms Lynn Patterson, Deputy Governor of the Bank of Canada, to the CFA Society Vancouver, Vancouver, British Columbia, 14 May 2015.
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Lynn Patterson: Fine-tuning the framework for the Bank’s market operations Remarks by Ms Lynn Patterson, Deputy Governor of the Bank of Canada, to the CFA Society Vancouver, Vancouver, British Columbia, 14 May 2015. * * * Introduction Good afternoon. Thank you, Geoff, for that kind introduction. And I want to thank as well the CFA Society for the invitation to speak here. It’s great to be among fellow charter holders. Like you, I made it through the three-year grind to achieve this designation. In fact, my topic today – the Bank’s market operations – may be an opportunity for some of you to revisit the fixed-income basics that we all studied. Many of you invest, raise funds or analyze markets, so I’m sure you follow the Bank of Canada’s monetary policy rate announcements. I spent many years during my career in a trading room and witnessed first-hand how quickly markets react and adjust to changes in the policy stance or target rate. As they do so, they help the Bank of Canada fulfill its two main responsibilities: the implementation of monetary policy and the promotion of the stability and efficiency of the Canadian financial system. Today, as a deputy governor at the Bank, observing how quickly and smoothly markets adjust confirms for me that the framework guiding the Bank’s operations is working well. But markets are dynamic and the financial ecosystem is always in flux. Like living ecosystems, it is constantly evolving and adapting to change. It’s important for us to be alert to shifts in its structure in order to help support its smooth and effective functioning. We aim to be proactive and respond to its evolution in a considered and calibrated fashion. In my remarks, I’ll discuss some of the shifts we are seeing in financial markets and highlight the changes we are proposing to fine-tune our operations. We recently posted on our website a consultation paper that discusses in greater detail the proposed adjustments that I will outline today. We are consulting market participants to ensure that the changes meet our intended objectives and are implemented seamlessly. A second consultation paper on modifications that we are proposing to support financial stability has also been posted. 1 Both were discussed in a speech by my colleague, Senior Deputy Governor Carolyn Wilkins, last week in Montréal. 2 I should also say here, just to be clear, that no inferences should be drawn from this speech and the proposals in the consultation papers about the current or future stance of monetary policy. Shifts in the financial system As I briefly touched on, the behaviour of market participants and the financial system are evolving. This is the result, in part, of lessons learned during the global crisis. Those lessons prompted regulatory changes to address the weaknesses that were identified. As a result, The consultation papers are available at www.bankofcanada.ca/2015/05/public-consultations-bank-canadaframework-financial-market-operations/. C. Wilkins, “Liquid Markets for a Solid Economy” (speech to the Chambre de commerce du Montréal métropolitain, Montréal, 5 May 2015). BIS central bankers’ speeches financial institutions have adjusted their operations, including how they manage their liquidity needs. In Canada, liquidity across the system has typically been distributed by the major banks and dealers. At present, there are 15 participating financial institutions in Canada’s large-value payment system. These firms have accounts at the Bank of Canada and execute payments with each other throughout the day. But primary dealers are the main counterparties to the Bank in its market operations. They can access and redistribute central bank liquidity more broadly over the normal course of business. Over the past few years, we have observed that financial institutionshave become somewhat less willing to borrow extra liquidity through our operations and redistribute it to others. It appears that they have become more focused on meeting their own liquidity needs. In addition, with the new Basel III regulations requiring institutions to hold high-quality liquid assets to better withstand liquidity shocks, demand for these assets has also increased. And many banks are rationalizing the use of their balance sheets, moving away from balancesheet-intensive and low-margin business lines. Given these changes, we have been reviewing our operating framework to assess its effectiveness. Let me describe how it works. The Bank’s Framework for market operations The Bank undertakes a range of financial market operations in the course of fulfilling our monetary policy and financial system responsibilities. Our operations include transactions to reinforce the target for the overnight rate, provide liquidity to financial system participants, acquire and manage assets on the Bank’s balance sheet, and lend a portion of the securities we hold. 3 Overall, our market operations framework is intended to achieve our policy objectives while minimizing our “footprint” in markets. As you may know, we announce our policy rate decisions on fixed dates, eight times a year. 4 The policy rate, in combination with expectations about our future policy stance and other factors, influences pricing along the entire yield curve, as well as a range of other asset prices. These, in turn, have a material impact on the economic decisions of households and businesses. 5 Ideally, we prefer the overnight market to clear on its own at close to the target rate through market forces rather than through our operations. We encourage this with an interest rate corridor, which is reinforced by standing deposit and lending facilities available to the participants in the payment system. 6 The corridor helps drive them to clear at the midpoint, which is the target rate. That’s the theory, and it works well in practice. However, there can be frictions. The Bank of Canada Act and the Payment Clearing and Settlement Act (PCSA) together give the Bank the power to make secured loans or advances to members of the Canadian Payments Association and operators of financial market infrastructures designated for oversight under the PCSA. The Bank can also purchase debt securities from any counterparty for the purposes of conducting monetary policy or promoting the stability of the financial system, subject to the policies established by the Bank. The Bank also retains the option of taking action between fixed announcement dates, although it would exercise this option only in extraordinary circumstances. Setting the overnight rate is the first stage of a long transmission mechanism by which monetary policy decisions ultimately affect inflation. The corridor is one-half of a percentage point wide and has the target for the overnight rate at its centre. See “A Primer on Canada’s Large Value Transfer System” and “A Primer on the Implementation of Monetary Policy in the LVTS Environment”. BIS central bankers’ speeches For example, sometimes the interest rate that is transacted in the overnight market starts to move off target during the day. The Bank typically intervenes if it judges that the deviation is the result of generalized pressures on liquidity in the overnight market, rather than because of firm-specific reasons. For such intraday frictions, the Bank can use repurchase or repo transactions called special purchase and resale agreements (SPRAs) or sale and repurchase agreements (SRAs) to add or withdraw intraday liquidity to or from the system to offset these pressures. So how we can we reduce the frictions and help enhance the flow of liquidity? Proposals for the overnight market We are proposing to adjust the format of these SPRA (and SRA) operations from offering primary dealers a fixed amount at the target rate, to a competitive and discriminatory price auction at market rates. We will also increase both the aggregate amount of each SPRA and SRA operation and the limit for each counterparty. These changes will allow firms that need liquidity to bid for a higher amount in any given round. We expect that this will help distribute liquidity more efficiently to those that need it most. At the same time, we may accept larger deviations from the target rate before we step in. Doing so will give the market more room to manoeuvre and clear itself without our intervention. These are the main proposed changes to our operations to reinforce the target for the overnight rate. Now, I’m going to turn to the enhancements we are proposing to support well-functioning markets. An important part of how we participate in markets is through the management of our balance sheet. Let me give you some details on that. The Bank’s balance sheet Like any company, central banks have balance sheets that need to be managed. At the Bank of Canada, our largest liabilities are bank notes in circulation and deposits from the federal government, which are mainly backed by the assets in our investment portfolio. Almost all of the $94-billion in assets held on our balance sheet consist of Government of Canada bonds and treasury bills. These are acquired on a regular basis through primary-market purchases on a non-competitive basis. 7 We follow three principles in acquiring these assets: prudence, transparency and neutrality. Prudence is exercised primarily by selecting assets that have a low credit risk. We achieve transparency by communicating our balance-sheet activities to the public. And to attain neutrality, we act as broadly and neutrally as possible to limit market distortions from our investment activities. At present, the composition of the Bank’s portfolio broadly reflects the composition of the federal government’s domestic debt. Going forward, we expect that the volume of bank notes in circulation will continue to grow roughly in line with the growth of nominal GDP. This will increase the Bank’s asset requirements. At the same time, the market demand for Government of Canada securities is also increasing. For example, the proportion of the federal government’s debt held by nonresidents has increased steadily. It has risen from almost 15 per cent in 2006 to just over The results of the Bank’s purchases, including the value of securities purchased and the price. BIS central bankers’ speeches 25 per cent in 2014. 8 One of the factors underlying this increase is that the Canadian dollar has become a more commonly held reserve currency in other countries. 9 Another factor is the Basel III regulations that I mentioned earlier which requires banks to hold more high-quality assets. Since government securities are among the safest and most liquid assets available, they have become more desirable. This is why, in Canada, federal government securities account for the majority of the collateral used in the repo market. Given these pressures and the expected future growth of the Bank’s balance sheet, absent any changes, we would have to buy a growing share of the outstanding stock of government securities. This would reduce the tradable float. Taken together, all of these factors could intensify liquidity pressures in the Government of Canada repo and cash markets. Indeed, we have already seen signs of this. The Bank has had to lend securities from its balance sheet to alleviate short-term imbalances in demand and supply more frequently over the past couple of years. Recognizing this shifting dynamic, we are proposing several enhancements to help support well-functioning markets. Proposals to support market functioning Term repos The first enhancement is the introduction of regular term repo operations as part of the routine management of the Bank’s balance sheet. We anticipate that the conduct of money market operations at longer maturities will not detract from our ability to influence the overnight rate. 10 Term repos will be useful to us from a policy perspective. They will help the Bank gather intelligence and analyze changes in liquidity conditions in short-term funding markets. In addition, they may encourage further development of the longer-term repo market in Canada. And conducting term repos on a routine basis will facilitate a quick response to future marketwide liquidity shocks. Term repos will also serve as a source of assets for the Bank’s balance sheet, allowing us to decrease our presence in the primary market for Government of Canada securities. We propose to commence these term repo operations in the autumn of 2015, with a sixmonth phase-in strategy to reach a steady state portfolio of $7 billion to $10 billion. This would amount to roughly 10 per cent of the Bank’s balance sheet. Purchasing Government of Canada securities in the secondary market Enhancement number two is a shift to the secondary market for some of the Bank’s purchases of Government of Canada securities, primarily non-benchmark bonds. Currently, our primary-market purchases of bonds amount to 20 per cent of every nominal bond auction. Figure for 2014 updated from J. Cruz Lopez, R. Mendes and H. Vikstedt, “The Market for Collateral: The Potential Impact of Financial Regulation,” Bank of Canada Financial System Review (June 2013): 45–53. According to the International Monetary Fund, in 2012 the Canadian dollar accounted for about 1.4 per cent or $87 billion of the foreign reserves held by other countries. Those numbers have since risen to 2 per cent or close to $120 billion (http://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4). A number of other central banks routinely conduct term repo operations. The Bank of Canada also undertakes them, but thus far only on an occasional basis. BIS central bankers’ speeches The introduction of term repos and secondary-market purchases will enable us to reduce our purchases at primary bond auctions to what we expect will be around 10 per cent. Using 2014 issuance figures, this would amount to an increase of about $9 billion in tradable float available across benchmarks. Our intent is to enhance liquidity in these benchmark securities and hold fewer of them, leaving more available to other buyers. These securities play a unique role in financial markets because they are used to price and hedge a variety of cash and derivative instruments. The Bank will maintain the maturity structure of the securities it purchases roughly in line with the profile of government debt outstanding. Securities lending The third enhancement is a change to some of the parameters of our existing securitieslending activities. Since 2002, the Bank has operated a program to lend a portion of its holdings when a specific bond or treasury bill is in high demand and is otherwise unavailable or trading below a certain threshold in the repo market. Lending our holdings provides a secondary source of liquidity, which helps maintain a well-functioning market. The program is designed to support efficient clearing and price discovery. Since 2013, a growing number of Government of Canada bonds have been trading at repo rates persistently below the overnight general collateral rate. As a result, the frequency of the Bank’s securities-lending has increased considerably. Repo tightness typically reflects an imbalance between the demand for, and availability of, certain securities in the repo market. Protracted repo tightness can affect the cash prices of these bonds and contribute to a reduction in market liquidity. It can also lead to an increase in settlement fails, where one party is unable to deliver the securities promised to its counterparty. To help support market liquidity, the Bank is proposing changes to the intervention threshold for its securities lending. At the moment, it appears that the Bank’s existing threshold is setting a de facto floor for market repo rates. In some circumstances the rate does not seem to be low enough to induce sufficient lending from private sector bondholders to meet demand. A lower threshold could help clear the market, while the Bank’s program would remain available to primary dealers as a backstop. The goal is to encourage Government of Canada securities holders, which may include not only domestic investors but also central banks and sovereign wealth funds, to lend out their securities before the Bank has to intervene. We act as custodian for 30 central banks and are currently implementing a number of measures that will allow them to more actively trade their holdings of Government of Canada securities, including in the repo market. Another element we are proposing is the introduction of a market-wide fail fee. Our own securities-lending program already includes such a fee. We are seeking feedback on whether the market should impose this kind of levy on trades in securities that fail to settle on time, as they do in the U.S. The main purpose for adopting it would be to reduce the risk of settlement fails and provide investors with additional financial incentives to lend securities that are in short supply. Contingent term repo facility Finally, after reviewing some of the ways that we dealt with short term funding needs during the crisis, we are proposing to develop a Contingent Term Repo Facility (CTRF). 11 This will During the global financial crisis, the Bank used a number of facilities that remain available should they ever be required again. The CTRF is an additional tool that would complement the Bank’s arsenal. BIS central bankers’ speeches enhance our ability to respond to future episodes of intense market-wide stress. The facility would be activated at the Bank’s discretion only when conditions warrant. Establishing the CTRF will ensure that the Bank has a permanent and flexible range of extraordinary liquidity facilities in place that could be activated to respond to and alleviate system-wide liquidity pressures. The CTRF would offer liquidity on a bilateral basis for customized variable terms of up to one month and be available to a range of counterparties, against a broad set of securities, at a fixed price. The specific parameters would be confirmed upon activation. We expect that if the CTRF were activated, the counterparties eligible would be primary dealers and their affiliates.However, the number of counterparties could be extended to include other institutions – subject to certain criteria – should the Bank consider it necessary for the stability of the financial system. Conclusion Let me wrap up by reiterating that the Bank’s operating framework is working well. We monitor our market operations closely to ensure that they are contributing to the maintenance and diversity of the financial ecosystem. Bearing in mind that a healthy system will feed economic growth, we have identified important areas for improvement. We think carefully about making changes to our framework because we recognize that doing so will affect markets. We want to make sure that any changes we propose are well thought out and include feedback gathered from market participants like you. The adjustments I have outlined are in response to the changes we are witnessing in financial markets. In addition to helping us achieve our framework objectives, they will benefit all market participants. I would like to thank Meyer Aaron, Stéphane Lavoie and Mark De Guzman for their help in preparing this speech. BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Greater Charlottetown Area Chamber of Commerce, Charlottetown, Prince Edward Island, 19 May 2015.
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Stephen S Poloz: The way home – reading the economic signs Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Greater Charlottetown Area Chamber of Commerce, Charlottetown, Prince Edward Island, 19 May 2015. * * * Introduction Good afternoon. It’s always a pleasure to be here in Prince Edward Island. The Confederation Bridge has simplified the trip since it first opened. If you come to the Island by car, you don’t have to navigate the waters of the Northumberland Strait. According to the Canadian Encyclopedia, the shallow waters of the strait are susceptible to strong currents, tides and turbulence. Even the most skilled sailor can find it challenging to read the winds and waves, and to judge all the cross-currents. If only the Canadian economy had a similar bridge. We’ve been on a voyage of rebuilding since the Great Recession. But the trip has been longer and more complicated than previous recoveries because of all the cross-currents acting on the economy. Not only are the headwinds of the global financial crisis still blowing, but now we’re also dealing with lower prices for oil and other key commodities, which previously were a key growth engine for us. The implications for income and investment, and the adjustments they’re causing across sectors and regions, may take years to work themselves out. The drop in oil prices is the most recent setback for the Canadian economy, but it’s not the first time we’ve had a shock that’s had different effects from one region to another. That’s what you’d expect in a large country that’s rich in diverse commodities. Certainly, people working in the lobster fishery or the mussel and oyster farming sector have seen their share of challenging periods in the past. But companies have adjusted and made quality improvements that are allowing aquaculture and the fishery to strengthen as the U.S. economy recovers. At the same time, P.E.I.’s exports are benefiting from diversification into sectors such as aerospace and biotechnology, as well as expansion into emerging markets, particularly Asia. P.E.I.’s experience is an example of the resilience that we’ve seen in the past across Canada. We’re expecting to see it again as the economy continues on its way home, toward natural, self-sustaining, and balanced growth at full capacity. What I’d like to do today is talk about how the voyage is going. We don’t have a bridge, so the economy can’t avoid the choppy waters. However, there are signs that tell us we’re headed in the right direction. It’s important for the Bank to be transparent about the signs we watch, both because financial markets should make their own judgments about what we will do and because our monetary policy works better when Canadians understand what we’re doing, and why. The long voyage home We begin the story with the Great Recession of 2008–09, which saw Canadian exports fall further than in any recession since the Second World War. Policy-makers everywhere reacted aggressively to the global turmoil. Here in Canada, governments boosted spending, and the Bank of Canada cut interest rates in steps until we reached the effective lower bound. These moves, combined with a strong financial system, gave Canada one of the best post-crisis experiences among advanced economies. It’s fair to say that households did most of the heavy lifting to keep the economy growing, borrowing to buy houses and cars. We also enjoyed good growth in our energy sector with high oil prices. BIS central bankers’ speeches But growth that relies too much on low interest rates and household spending isn’t sustainable. We kept looking for signs that a natural sequence was taking over in the economy: recovery in the United States and elsewhere would lead to stronger exports. This would spark increased business confidence, investment and employment. Ultimately, we would achieve natural, balanced growth, with exports representing a larger share and inflation sustainably at its 2 per cent target. Exports began to recover after the recession but stalled in 2012 and 2013, despite strong U.S. growth. So, at the Bank of Canada, we did a lot of work to figure out what was going on, looking at how the drivers of exports were evolving, including the competitiveness of various sectors and the loss of productive capacity in the wake of the recession. We looked at 31 categories of Canada’s non-energy exports and found that about half of them were underperforming relative to what you’d expect, given the state of foreign demand and the exchange rate. We further broke those weak categories into about 2,000 specific goods or services and discovered that about 500 of those had been shrinking since the early 2000s, falling to almost nothing. We were able to show that much of this drop was due to companies in these areas ceasing to operate in Canada. So, their productive capacity has been permanently lost. But what about the other half of the non-energy export sector? Those 15 categories are expected to lead the recovery in exports, based on factors such as their ties to U.S. residential and business investment and their historical sensitivity to exchange rates. The list includes such categories as machinery and equipment, fabricated metal products, aerospace, and pharmaceuticals; in many of these, we’re seeing growth right here in P.E.I. That’s not to mention services, which includes tourism. If you think back to last summer, the economic outlook was looking pretty positive. The export groups that we predicted would lead the recovery were starting to perform as we expected. The price of Brent crude oil was over US$100 per barrel, and the global economy seemed set to strengthen as economic headwinds were dissipating. The U.S. economy was looking especially good, and this was making us more confident that the natural progression was taking place and we were on our way to solid, self-sustaining growth. Of course, we all know what happened next. The plunge in oil prices late in the year threw the recovery off course. It was clear that the shock would be a net negative for the Canadian economy and would be a downside risk for our inflation target, so we lowered our key policy interest rate in January. But while it was clear that the oil price shock represented a setback, it has been no simple task to figure out how far off course it is taking us, or for how long. From the data we have seen to date, the impact began to show up in the closing months of 2014. For example, oil rig counts began to fall, and this showed up in employment statistics in the oil patch, especially in Alberta. This impact contributed to weaker growth in housing and general consumption spending. Manufacturing faltered as we moved into 2015, partly because many inputs for the oil patch are manufactured, but also because of bad weather and a temporary slowdown in the U.S. economy. When all the numbers are in, we expect that output in the Canadian economy will have been basically flat in the first quarter. Our view, as we set out in last month’s Monetary Policy Report, is that growth will rebound partially in the second quarter. While there’s still a risk that lower oil prices could have a greater impact, the signs we have seen to date lead us to believe that the impact of the shock is proving to be faster than we first expected, but not larger. Meanwhile, the positive forces we had already identified continue to build and should be buttressed by our interest rate cut and the lower dollar. By the second half of the year, we expect those positive forces to dominate the picture and have us back on track to reach full capacity around the end of 2016. BIS central bankers’ speeches What are we basing this outlook on? For one thing, the January interest rate cut is working. In an atmosphere where many other central banks were also loosening policy, the reaction to the cut made financial conditions in Canada significantly easier. The cut will benefit households with a mortgage, though this will be partly offset by a reduction of income for savers. Let me put this in concrete terms. Bank staff estimate that a household that has renewed a $100,000 mortgage would save about $250 in interest payments this year. That’s on top of the roughly $500 that the average household will save in gasoline costs. But the really big impact is for companies with existing export contracts in U.S. dollars, which would see a bump in cash of roughly $15 billion to $20 billion over the course of the year from a threecent drop in the Canadian dollar. They will also be in a stronger position to compete for new export contracts in the future. Of course, I must underscore how uncertain the outlook is. In recent weeks, both oil prices and the Canadian dollar have moved higher. We will need to carefully consider these and other economic and financial developments and how Canadian companies and households are likely to react in the months ahead. Now, let’s look at the categories of non-energy goods exports that we said should lead the recovery. As a whole, this group – which adds up to more than $185 billion – grew by almost 15 per cent in nominal terms over the 12 months through March. Among industries present in P.E.I., aerospace is up by 20 per cent nationally, while machinery and equipment has risen by about 11 per cent. Here in P.E.I., exports climbed by 22 per cent last year, with the total now exceeding $1 billion. Tourism, another industry important to both P.E.I. and Canada as a whole, also had a good year. Foreign tourism demand grew 4.5 per cent to reach the highest level in a decade. Given lower gasoline prices and the level of the Canadian dollar, we can expect further growth this year. What about the next steps in the sequence: the increases in company investment and employment? When we spoke with executives in our most recent Business Outlook Survey, we heard that companies that are benefiting from stronger U.S. demand are starting to feel capacity pressures, and a growing share of exporters tell us that capacity constraints would limit their ability to meet a sudden increase in demand. These constraints suggest that companies may need to step up investment. To be sure, there is some spare capacity among the groups that we expect to lead the recovery. However, outside of the energy sector, the outlook for investment is positive. In terms of employment, there have been some recent signs that the labour market is starting to function better. Let me give you some examples. We’ve seen long-term unemployment decline and more prime-age people taking part in the labour force. Employment vacancies have been trending upward since early last year, suggesting that it’s getting easier to move jobs. Statistics Canada’s Survey of Employment, Payrolls and Hours shows that manufacturing jobs have trended up for the past six months or so. However, the Bank’s own indicator shows that there’s still slack in the labour market, and we probably still haven’t seen the full impact of the oil price shock reflected in the employment data. Let me mention one other bellwether, and that’s firm creation. While part of the increase in business investment will be companies adding to their own capacity, another part will be the creation of new companies. Historically, growth in the population of companies tends to be weak when the economy is weak and stronger when the economy improves. New firms are the prime creators of new jobs in the economy. They are also linked with productivity growth, because new companies are often innovators or take advantage of innovations to exploit niches and develop new products. New companies tend to be more productive than firms that have gone out of business and can also pressure existing companies to be more productive. As such, they BIS central bankers’ speeches contribute to the growth in productivity that is ultimately key to improving our standard of living. Recessions are painful and require adjustments. Companies, and sometimes entire industries, shut down, often never to return. But after the destruction, new ones are born that help drive the next wave of growth. We know that we lost a lot of exporting companies during the recession. Growth in the population of companies hit a low point in Canada in 2009, similar to what took place in the United Kingdom and United States. After the recession, the number of U.K. companies started growing sharply in 2012 and the U.S. population took off in 2013. The Canadian rebound hasn’t been as quick as we’d like, but recent data have been encouraging. We will continue to follow these data closely. Of course, these aren’t the only signs we’re following. We look at a wide range of economic data and supplement these with various surveys. We also consult with business leaders, and our regional offices are invaluable in these efforts. All of this information helps us make our best judgment about how much slack there is in the economy or, in other words, how far we are from home. Judging inflation Our judgments about inflation are truly important because they get at the heart of our mandate at the Bank of Canada. It’s our job to promote the economic and financial welfare of Canadians, and the best way we can do that is to provide an environment of low and stable inflation. Why? Because low and stable inflation allows consumers and businesses to make decisions about the future with greater certainty. Since the Bank began targeting inflation almost 25 years ago, interest rates have been lower and economic growth has been stronger and more stable. We know that inflation is fundamentally driven by the amount of economic slack we have. If the economy is operating below its capacity, that will put downward pressure on inflation. However, inflation is a noisy indicator. All sorts of things can affect it on a month-to-month basis. Our task of judging the underlying trend of inflation has been complicated by the events of the past year. We have the oil price shock, which is pushing inflation down, and the weaker Canadian dollar, which is pushing inflation upward. On top of these, a number of one-off factors have been affecting inflation. All of this has certainly made it more challenging to distinguish the trend from the temporary. Because it takes up to two years for interest rate movements to have their full impact on inflation, it wouldn’t make sense to respond to every wiggle in the inflation rate. Our challenge is to look through the temporary effects and aim our policy at the movements in inflation that are persistent. And to do that, we need to make our best judgment of what the underlying trend of inflation is. We have a number of measures that we use to help us make this judgment. The most familiar of these is commonly referred to as our measure of “core inflation,” which excludes eight of the most volatile components of the consumer price index and removes the effects of changes in indirect taxes. But we have several other methods, models and tools, which help us judge the underlying trend of inflation. Next year, the Bank will renew its inflation-targeting agreement with the government. As we have been saying for months, among the issues we are looking at in this renewal is whether we should continue to highlight one measure of the underlying trend of inflation, and, if so, whether our current measure of core inflation should continue to be the main guide. At the most recent reading, total CPI inflation was 1.2 per cent, well below our 2 per cent target. This was largely due to the drop in gasoline prices, which we treat as a temporary effect. Total CPI inflation would be even lower – quite close to zero – were it not for BIS central bankers’ speeches exchange rate effects and some one-time factors. Meanwhile, core inflation was 2.4 per cent, but it is also being boosted by exchange rate effects and some one-time factors, such as meat and communications prices. That’s a lot of moving parts, and the impact of each of these transitory forces has to be estimated; we can’t just measure them. So we have to use a lot of judgment to gauge the combined impact. Clearly, these estimates are subject to a fair degree of error. But our current best judgment is that the underlying trend of inflation is somewhere around 1.6 per cent to 1.8 per cent. To get the trend moving back toward 2 per cent, it’s essential that excess capacity in the economy be used up. With growth set to accelerate over the rest of the year, the underlying trend should eventually converge with total CPI inflation at the 2 per cent target when the economy returns to full capacity. Here’s the bottom line on our voyage. We’re still a ways from home; we project it will take 18 months or so to get there. That’s if growth turns out as we expect and we aren’t hit by other storms or cross-currents on the way, whether headwinds or tailwinds. But our best judgment is that we should get home – at full capacity and with inflation sustainably at 2 per cent – around the end of 2016. Conclusion Let me conclude with a few words about what home will look like when we do get there. While some companies disappeared during the Great Recession, never to return, others are emerging in new industries. At the same time, the economy of the future will be shaped by demographic forces that have been decades in the making. The retirement of the baby-boom generation is affecting the economy’s growth potential, which is one reason why interest rates will probably remain lower than in the past. Recent events make it clear that we live in an uncertain world. Navigating the waters of the global economy is always challenging: you never know when a sudden storm will emerge to blow us off course. That’s why we take a risk-management approach to monetary policy. We look at all the data, derived from the latest models and tools, and supplement these with intelligence from companies and survey data. Ultimately, though, we make judgments – both about the degree of economic slack in the economy and the implications for our goal of inflation control. By being transparent about the signs we’re watching, we are trying to help financial markets make their own judgments about the economy’s prospects. These opinions are important because they serve as a useful check on our own analysis. It has been a long voyage, and it isn’t over yet. But you can be sure that the Bank of Canada will continue to work toward bringing the economy home, at full capacity and with inflation sustainably on target, so we can fulfill our mandate to support the economic welfare of all Canadians. I would like to thank Pierre St-Amant, Marc-André Gosselin and David Amirault for their help in preparing this speech. BIS central bankers’ speeches
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Panel remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, for round table discussion at the 21st Conference of Montréal: International Economic Forum of the Americas, Montréal, Quebec, 8 June 2015.
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Carolyn Wilkins: Panel remarks for round table discussion at the 21st Conference of Montréal Panel remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, for round table discussion at the 21st Conference of Montréal: International Economic Forum of the Americas, Montréal, Quebec, 8 June 2015. * * * Introduction Thank you for the invitation to be here today. I’m honoured to be part of this panel. It’s been more than seven years since the global financial crisis began, and we’re still coping with its aftermath. One of the consequences of the crisis has been a disruption of financial globalization. Global capital flows – to give just one measure – have fallen by more than half from their pre-crisis peak of over US$8 trillion. 1 I’ll spend a few minutes on why we’re seeing this fragmentation. I’ll then offer my views on what we should do to realize the full benefits of financial globalization and manage the risks associated with it. Causes of fragmentation The retreat from financial globalization that we’ve seen reflects cyclical economic forces, such as the slowdown of global trade and investment. It also reflects structural adjustments, including the deleveraging undertaken by banks to repair their balance sheets and respond to regulatory changes. None of this should come as a surprise, given what we’ve been through. On the cyclical side, the crisis has cost the world economy as much as US$10 trillion in lost output, or almost 15 per cent of production. Global trade slowed, as did the demand for the international financial services that support it. The share of trade in GDP fell after the crisis, reversing some of the 20-percentage-point increase over the two decades that preceded it. 2 On the structural side, financial institutions that experienced losses during the crisis had to repair their balance sheets by scaling back their lending – not only at home but especially internationally. Trade, commodities and infrastructure financing were particularly hard hit. Since the crisis, banks have more than doubled the amount of common equity capital they hold. While doing this, banks have tended to focus on their home market and the best ways to allocate capital in the new environment. Rules such as anti-money laundering and counter terrorism financing laws may also be altering the terrain. Financial institutions have also had to respond to regulatory changes. For example, derivatives dealers appear to be doing more business with domestic counterparties in part because of more stringent, and sometimes inconsistent, rules. 3 While the level of cross- The Institute of International Finance, “Financial Globalization: Maximizing Benefits, Containing Risks” December 2014. M. Francis and L. Morel, “The Slowdown in Global Trade”, Bank of Canada Review (Spring 2015): 13–25. S. O’Malia, “No Answer Yet to Cross-Border Concerns”, International Swaps and Derivatives Association, 11 May 2015. BIS central bankers’ speeches border activity in this area is still robust, one study finds that regulatory changes can explain roughly half of the drop in cross-border claims since before the crisis. 4 To put things in perspective, total foreign banking claims measured as a share of global GDP have fallen by one-third since 2008, to 39 per cent at the end of 2014. 5 This fragmentation is of concern to people like me, who believe that open global financial markets are generally a good thing for economies because they facilitate the most efficient allocation of capital and boost growth. At the same time, the crisis taught us that integrated markets also entail risks that need to be properly managed. We know that, unchecked, financial globalization could increase procyclicality and make financial cycles larger. 6 In other words, booms and busts could become more frequent and more destabilizing. And it’s possible that international financial flows were inflated by excessive growth in finance relative to global GDP. 7 So authorities have to find the right balance between encouraging globalization and guarding against its risks. Getting the right balance Progress is being made globally. We have put in place a framework to better manage the risks that come with financial globalization through reforms agreed to by G-20 leaders. The Basel Committee on Banking Supervision has established new rules for banks, and the Financial Stability Board (FSB) published its Key Attributes of Effective Resolution Regimes for Financial Institutions. These are big steps in the right direction. Some of these reforms have been substantially implemented. I’m talking about the Basel III rules, which impose more stringent standards on capital and liquidity and a surcharge for systemically important banks, and the Principles for Financial Market Infrastructures, which establish higher standards for central counterparties and other systemically important infrastructures. A level playing field on this is supported by peer reviews conducted by the FSB to ensure consistent implementation in different countries. At the national level, recovery and resolution regimes are being introduced to further protect taxpayers and minimize systemic disruption in the event that a domestic systemically important bank (D-SIB) fails. Canada has made good progress in putting in place the G-20 reforms in the spirit in which they were intended. We’ve implemented Basel III ahead of schedule and started work on recovery and resolution plans for D-SIBs. Some jurisdictions have also made rules that deliberately separate different parts of their financial systems. For example, some have enacted changes to ring-fence retail banking activities within banking groups to limit the funding of investment banking activities with deposits backed by government safety nets – Vickers in the United Kingdom and Volcker in the United States. International Monetary Fund, Navigating Monetary Policy Challenges and Managing Risks, Global Financial Stability Report, April 2015. Based on calculations using data from the Bank for International Settlements (BIS) (Consolidated Banking Statistics) and the International Monetary Fund (World GDP, from the World Economic Outlook (WEO) database). C. Borio, “The International Monetary and Financial System: Its Achilles Heel and What to Do about It”, BIS Working Paper No. 456, September 2014. In the decade leading up to financial crisis, global banks’ cross-border claims as a share of world GDP increased tenfold, from 6 per cent in 1995 to 60 per cent in 2007. BIS central bankers’ speeches Every jurisdiction has different requirements, and our view is that we must ensure that jurisdictions don’t go too far down the road toward more domestically oriented financial system reforms. In an interconnected world, the actions of one country affect others. If all jurisdictions act in their own national interest, narrowly defined, everyone could be left worse off. Co-operative outcomes are superior. Mutual recognition This points to the need for coordination among regulators. The G-20 reforms can make the world safer for international capital flows only as long as there is consistent implementation of international standards and mutual recognition among authorities. If we fail to achieve this, we could end up with inconsistent and incomplete regulations that impede desirable flows and create scope for circumvention. Canada has stayed away from imposing structural reforms that would create a separation between commercial and investment banking activities, focusing instead on a principlesbased approach. Historically, Canadian banks have benefited from diversification in their business lines, and the consolidated supervision of the banking group by the Office of the Superintendent of Financial Institutions has been effective. 8 A lot of work remains at the international level. It hasn’t been easy to agree on plans to coordinate cross-border recovery and resolution for global systemically important banks (G-SIBs), and not for a lack of effort and goodwill on the part of the home and host authorities. One major step was taken in October, when 18 G-SIBs agreed to a protocol established by the International Swaps and Derivatives Association that will give authorities more time to organize an orderly resolution of a troubled bank. The success of this mechanism depends on its broad adoption by market participants, so industry also has a responsibility here. If multilateral agreements prove intractable, bilateral agreements could be another way to reach the same goal, in light of the trend toward regional banking. In time, successful bilateral agreements could even serve as models for more ambitious multilateral agreements. Conclusion Let me wrap up. The global financial system is important to Canada. We’re a small, open economy, highly dependent on global trade. That means we rely on cross-border financial flows to fund exports and investment. And Canadian banks have continued to increase their foreign presence in the post-crisis period. In the past five years, their foreign claims have risen by 70 per cent. This is why Canada is pushing for consistent implementation of global rules. With more homogeneous financial regulation and good co-operation on supervision, we will achieve solid prudential outcomes, build trust and reduce the tension that contributes to ring-fencing and fragmentation. While there are still some challenges at the international level, notably around the resolution of international banks, we continue to make progress. As the reform agenda is implemented, we’ll see an improvement in global financial flows. We probably won’t get back to the pre-crisis pace of globalization. This pace was probably unsustainable anyway. We should nonetheless achieve close to the right balance between sustainable growth and financial stability. I’d like to thank Paul Chilcott and Alexandra Lai for their help in preparing these remarks. M. Zelmer, “Promoting a Safe and Sound Financial System: Lessons from the Goose That Laid the Golden Egg” (remarks to the 2012 Canadian Financial Services Insolvency Protection Forum, Toronto, 21 November 2012). 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Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, to the Windsor-Essex Regional Chamber of Commerce, Windsor, Ontario, 25 June 2015.
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Lawrence Schembri: Building trust, not walls – the case for cross-border financial integration Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, to the Windsor–Essex Regional Chamber of Commerce, Windsor, Ontario, 25 June 2015. * * * Before I built a wall I'd ask to know What I was walling in or walling out, And to whom I was like to give offence." —Mending Wall by Robert Frost Introduction Good afternoon. Thank you for the invitation to speak to you today. I am especially pleased to be in Windsor in 2015, which marks the 50th anniversary of the path-breaking Canada– U.S. Auto Pact.11 The benefits of the pact and subsequent Canada–U.S. trade agreements are plainly evident in the steady flow of commercial traffic here at Canada’s busiest border crossing. Windsor residents understand better than most that Canada remains the largest trading partner of the United States. In 2014, trade between our countries amounted to more than $850 billion—40 per cent of Canada’s entire GDP. You also understand that this high level of trade is not just a feature of geography. It is the result of almost 200 years of good-neighbour collaboration, founded on trust, not walls. As a result of these co-operative efforts, we have achieved a high degree of cross-border access and economic integration that is the envy of the world. And most importantly, both countries have benefited. Today, I want to talk to you about cross-border financial collaboration, another key aspect of our relationship with the United States, as well as with other countries. We all know that a well-regulated and globally integrated financial system is essential for promoting trade and achieving sustainable economic and employment growth. However, the recent global financial crisis clearly demonstrated that while financial systems are indeed highly integrated across countries, many were inadequately regulated and supervised. In Canada, our financial system was, and is, well regulated and supervised. No Canadian banks failed during the crisis. 2 The strength of our financial system helped us avoid the worst of the damage. Yet, we still lost 430,000 jobs and our exports plunged by more than 16 per cent. 3 That experience taught us a valuable lesson. In a trading economy like ours, keeping our own financial house in order is not sufficient to shelter us from global financial storms. We need financial stability not just within countries but across them. The G-20 responded to the crisis with a comprehensive financial reform agenda, coordinated by the Financial Stability Board (FSB), to address the exposed weaknesses, to promote global financial stability, and to enhance financial and economic integration. Since then, FSB member countries have made unprecedented progress on these objectives. Canada and the United States have signed three major trade liberalization agreements over the past 50 years: the 1965 Auto Pact, the 1988 Canada–U.S. Free Trade Agreement and the 1994 North American Free Trade Agreement, which also included Mexico. The banking system did, however, require significant liquidity support because of the severe disruption to global funding markets. M. Carney, “Exporting in a Post-Crisis World” (speech to the Greater Kitchener-Waterloo Chamber of Commerce, Waterloo, Ontario, 2 April 2012). BIS central bankers’ speeches I’ll start with a brief overview of important reforms to the global banking system and to shadow banking—which refers to credit intermediation activities outside the traditional banking system—that have made the financial system as a whole safer. 4 Then, I’ll zero in on two reform areas that need more work: global banks that are “too big to fail” and over-thecounter (OTC) derivatives markets. Finally, I’ll say a few words about a third policy issue that is critical for supporting financial integration—cross-border payments. Reforming the financial system Led by the G-20, the FSB and the international standard-setters are developing and monitoring the implementation of the required regulatory standards. 5 Their successful reform efforts have helped rebuild trust in financial integration that was severely damaged by the crisis. A significant accomplishment is the Basel III framework, which has made global banks much stronger and more resilient. The framework, which requires banks to hold more capital and liquidity and imposes a backstop leverage limit, has largely been finalized. 6 Although the deadline for full implementation is not until 2019, many jurisdictions, including Canada, are well ahead of schedule. 7 As for shadow banking activities, they represented key sources of financial instability during the crisis through faulty subprime mortgage securitization and runs on money market funds and repo markets. The FSB is creating a comprehensive approach to monitor and assess these non-bank credit intermediation activities. Regulatory standards have been developed for several of the activities. For example, standards exist for securitization, specifically risk retention and disclosure; money market funds, including liquidity and valuation; and repo and securities-lending transactions, chiefly minimum haircuts. Several other types of shadow banking entities, such as broker-dealers, investment funds and finance companies, have been categorized by their economic function within a principles-based regulatory framework. Policy tool kits have been developed for each. Implementation of these standards is ongoing globally and in Canada and will be monitored and promoted by country and thematic peer reviews conducted in 2015. The next priority is to make further headway on the two areas I mentioned earlier—ending the threat of banks considered too big to fail and improving the safety of OTC derivatives markets—that pose complex cross-border issues. Ending Too big to fail To address the problem of too big to fail, most clearly exemplified by the hugely disruptive failure of Lehman Brothers in September 2008, the FSB has taken three bold policy actions. The FSB reform objective for shadow banking is to transform it into resilient market-based finance. The international financial standard-setters include the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO), the Committee on Payments and Market Infrastructures (CPMI), and the International Association of Insurance Supervisors (IAIS). Basel III “is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of banks.” See www.bis.org/bcbs/basel3.htm. The Office of the Superintendent of Financial Institutions (OSFI) has obliged Canadian banks to meet or exceed Basel III standards on an accelerated timetable. For example, since 2013, Canadian banks have been required to hold at least 7 per cent of Common Equity Tier 1 capital, compared with the Basel requirement to hold 4.5 per cent by 2015. OSFI has also required full implementation of the Liquidity Coverage Ratio (LCR) beginning in 2015, rather than the 2019 requirement under Basel III. BIS central bankers’ speeches First, the effectiveness of the supervision of large internationally active banks has been increased. Second, approximately 30 of the most systemically important global banks—those so large that their failure would have an impact on the entire financial system—have been identified and will have to hold more capital to make them safer and discourage them from becoming even more systemically important. At this point, there are no Canadian banks on this list. In Canada, however, the Office of the Superintendent of Financial Institutions (OSFI) identified six of our banks as systemically important at the domestic level, mandated that they hold 1 per cent more capital and strengthened its oversight of them. Third, and perhaps most significant, the FSB has developed a set of policy standards, known as the Key Attributes for Effective Resolution Regimes, to resolve these global banks when they become non-viable. 8 The objective of resolution is to maintain their critical functions, such as deposit taking, payments and lending, without disrupting the financial system and without taxpayers being the first line of defense. 9 The Key Attributes were a major breakthrough, and these standards are gradually being implemented. However, because these global systemically important banks operate in many jurisdictions through subsidiaries and branches, we need to tackle a number of difficult cross-border home-host issues. For example, whose rules will govern the resolution, those of the home jurisdiction of the parent bank or those of the host jurisdiction of the subsidiary or branch? Where will the capital to absorb losses be held? In the parent bank? The subsidiary? How do we ensure that cross-border financial contracts are maintained and not torn up in resolution? The FSB is methodically addressing each of these questions and making solid progress. 10 In the meantime, there is a risk that some countries, understandably concerned about the safety of their own financial systems, may take measures that run counter to the spirit of the G-20 reforms to promote financial integration. An example of this is the set of rules governing foreign bank operations in the Dodd-Frank Act of 2010, the most comprehensive reform of the financial system that the United States has undertaken since the Great Depression. 11 Under Dodd-Frank, subsidiaries and branches of international banks of a certain size will have to meet separate capital and liquidity requirements inside the United States. 12 The Key Attributes are 12 essential features that the FSB considers necessary for the resolution regimes of all jurisdictions. See www.financialstabilityboard.org/2014/10/r_141015. In the 2015 federal budget, the government announced that it plans to adopt measures to ensure that “systemically important banks’ shareholders and creditors are responsible for bearing losses, thereby giving them stronger incentives to monitor banks’ risk-taking activities.” One of the measures “would allow for the permanent conversion of eligible liabilities of a non-viable bank into common shares.” See www.budget.gc.ca/2015/docs/plan/toc-tdm-eng.html. See also the Department of Finance’s consultation paper on bank recapitalization, at www.fin.gc.ca/activty/consult/tpbrr-rpcrb-eng.asp. The FSB’s progress report on resolution regimes is available at www.financialstabilityboard.org/2014/11/report-to-the-g20-on-progress-in-reform-of-resolution-regimes-andresolution-planning-for-globally-systemically-important-financial-institutions-g-sifis. See sections 165 and 166 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, at www.sec.gov/about/laws/wallstreetreform-cpa.pdf. The Fed’s final rule on strengthening the supervision and regulation of foreign banking organizations is available at www.federalreserve.gov/newsevents/press/bcreg/20140218a.htm. BIS central bankers’ speeches What does this mean for Canadian banks? Our largest banks have sizable U.S. operations. Some will likely meet the size threshold and will be subject to these new requirements. These national rules will not only impose new legal and administrative costs on Canadian banks, but might also constrain their ability to allocate capital and liquidity efficiently in the North American market. 13 And if a Canadian bank with U.S. subsidiaries were to fail, it bears asking whether the pre-emptive actions of U.S. authorities would create obstacles for the orderly resolution of the consolidated bank by Canadian authorities, led by the Canada Deposit Insurance Corporation. This “one-size fits all” approach overlooks the existing degree of integration between our two economies, Canada’s impressive record for financial stability and the fact that Canadian banks have long been active and well trusted in the United States. 14 That, in brief, is where we stand at the moment on cross-border bank-resolution issues. And, as you will see in a minute, the cross-border issues related to OTC derivatives are equally complex. Making Over-the-counter derivatives markets safer OTC derivatives were largely unregulated before the crisis. For example, when Lehman Brothers failed, it had roughly one million outstanding derivatives contracts. No one outside the company knew the full extent of Lehman’s exposures. Uncertainty rippled through the market, spreading fear about the solvency of other banks and impairing the functioning of markets. This experience highlighted the interconnectedness within markets and how the failure of one institution can pose a systemic risk that threatens the entire financial system. Under the G-20 reforms aimed at reducing systemic risk, countries have agreed to report all transactions to trade repositories and to centrally clear all standardized contracts. Again, much progress has been made on improving the reporting and central clearing of transactions. 15 The challenge ahead is to ensure that the rules for on-the-ground implementation of some of these reforms are consistent across jurisdictions. To understand how complicated this is, it is useful to compare the processes for the Basel III framework with that for OTC derivatives. Because the Basel Committee already had granular rules for bank regulation, a process was established to achieve a multilateral consensus on the next set of bank standards. For OTC derivatives, no such process existed because they had previously been largely unregulated. The United States—the jurisdiction most affected by the crisis—was the first to respond, with the Dodd-Frank Act. Other countries were slower off the mark, and this has led to differences For well over a century, major Canadian banks have safely raised funding and managed liquidity through branch operations in U.S. money markets. See, for example, C. A .E. Goodhart, The New York Money Market and the Finance of Trade, 1900-1913 (Cambridge: Harvard University Press, 1969). In C. W. Calomiris and S. H. Haber, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit (Princeton: Princeton University Press, 2014), the authors remark that “the extraordinary stability of the Canadian banking system has been one of its most visible and oft-noted characteristics for nearly two centuries.” The third OTC derivatives reform priority, expanding the use of trading platforms, is being implemented more gradually. BIS central bankers’ speeches in implementation, especially among major jurisdictions. 16 These differences are slowly being resolved. 17 In the meantime, market participants are trying to cope with these regulatory inconsistencies. As a consequence, the costs of cross-border trade are rising and markets are starting to fragment. Canada and other jurisdictions are caught in the middle. One of the ways countries are managing these inconsistencies is by recognizing each other’s regulatory approaches when they achieve similar prudential outcomes. In this regard, the U.S. Commodity Futures Trading Commission (CFTC), which took the lead in OTC derivatives rule-making in the United States, has recognized that OSFI’s requirements are equivalent to the U.S. rules in a number of cases. 18 However, the Commission still wants Canadian banks to submit to its oversight, which could include on-site visits. Canadian and U.S. authorities are working together to limit the additional burden this places on affected banks. As noted, monitoring exposures in the derivatives market is important for helping to reduce systemic risk. To do so, authorities need access to transactions data held in trade repositories. However, a provision in Dodd-Frank that requires authorities using these data to sign an indemnity in the event of their misuse effectively precludes the Bank of Canada, OSFI and others (including the U.S. Federal Reserve) from obtaining this information. 19 Consequently, the data on OTC transactions performed by Canadian banks and reported by them to U.S. trade repositories are currently not being used to assess systemic risk in the OTC derivatives market. To summarize, national authorities should strive to build trust and achieve more cross-border recognition of comparable regulatory requirements. Such an approach would reduce regulatory uncertainty and enhance the ability of market participants—ranging from global banks to small factory owners and farmers—to hedge risks and protect themselves from economic shocks. Improving cross-border payments Let me turn now to cross-border payments, an issue that all of you have likely had some experience with as consumers or in your businesses. As you know, sending funds to or receiving them from the United States or any other country is slow, inconvenient and costly. S. O’Malia, “No Answer Yet to Cross-Border Concerns,” International Swaps and Derivatives Association, 11 May 2015. Available at http://isda.derivativiews.org/2015/05/11/no-answer-yet-to-cross-border-concerns. The Financial Stability Board publishes an annual report on the implementation of reforms in the OTC derivatives market. The 2014 report is available at www.financialstabilityboard.org/2014/11/eighth-progressreport-on-implementation-of-otc-derivatives-market-reforms/. The Dodd-Frank Act allows exemptions where there is comparable, comprehensive supervision and regulation in the home country. See Sections 725 and 733 of the Dodd-Frank Act. Sections 728 and 763 of the Dodd-Frank Act require U.S.-based trade repositories to obtain a written indemnification agreement from the authorities confirming that they will indemnify the trade repository and the U.S. regulatory commissions for any expenses arising from litigation relating to the information. The CFTC has released an interpretative statement allowing some access to data reported under non-U.S. regulatory regimes but has applied this only to authorities that directly regulate the trade repository. In recent speeches, Federal Reserve Board governors Lael Brainard and Jerome Powell have called for increased data transparency regarding OTC derivatives. See L. Brainard, “The Federal Reserve’s Financial Stability Agenda” (speech at the Hutchins Center on Fiscal and Monetary Policy, Washington, D.C., 3 December 2014); and J. Powell, “Financial Institutions, Financial Markets, and Financial Stability” (speech to Stern School of Business, New York, 18 February 2015). BIS central bankers’ speeches You won’t be surprised to hear that a recent report by the Federal Reserve described crossborder payments in much the same way. 20 And you’ll be pleased to hear that the Fed and the Bank of Canada are working with the financial industry, including payments associations, to promote efforts within their respective jurisdictions to modernize cross-border payments. 21 In its report, the Fed argued that the U.S. payments system is at a critical juncture because of three factors: • technological advances in high-speed data networks; • the related need to ensure the safety and security of payments; and • user demands for faster, less costly domestic and cross-border payments, manifested by the growth of other means, such as PayPal. To improve cross-border payments, a number of key barriers need to be addressed. They range from regulatory requirements for anti-money laundering rules to a lack of standardization of electronic formats. Standardizing formats would allow more business information to be transmitted with payments. These barriers are not easy to overcome. Resolving them, however, will significantly increase efficiency and greatly reduce the costs of cross-border payments. Building trust to move forward What can we do to overcome these challenges to cross-border integration? The ideal, of course, would be a broad agreement among all G-20 members. But securing a multilateral compromise could take several years. Still, we shouldn’t abandon this possibility. The FSB has helped build trust through its consensus-forming processes and should continue to press for the timely development and consistent implementation of global minimum standards. 22 In this vein, and especially with regard to Canada, we should urge U.S. authorities to respect the G-20 leaders’ agreement at the 2014 Brisbane Summit to defer to each other’s regulatory requirements when they achieve a similar prudential outcome. 23 If this were to occur, Canada would clearly benefit, given its strong and crisis-tested regulatory and supervisory framework. At the same time, it would be wise to consider alternative approaches. See Payment System Improvement—Public Consultation Paper, The Federal Reserve Banks, 10 September 2013, https://fedpaymentsimprovement.org/wp-content/uploads/2013/09/Payment_System_ImprovementPublic_Consultation_Paper.pdf. The Fed’s strategies for improving the payment system can be found at: www.federalreserve.gov/newsevents/press/other/20150126a.htm. In Canada, the Canadian Payments Association is leading the work to modernize the payments system. For details on improvements to the payments system in Canada, see L. Embree and P. Miller, “Improving the Foundation of Canada’s Payments System,” Bank of Canada Review (Spring 2015: 26–34) and L. Schembri, “A Dual Vision for the Canadian Payments System (speech to the Canadian Payments Association, Charlottetown, Prince Edward Island, 27 June 2014). For FSB Chair Mark Carney’s most recent report on too-big-to-fail initiatives and other issues, see www.financialstabilityboard.org/2015/04/fsb-chairs-letter-to-g20-on-financial-reforms-progress-on-the-workplan-for-the-antalya-summit. The G-20 leaders agreed that “jurisdictions and regulators should be able to defer to each other when it is justified by the quality of their respective regulatory and enforcement regimes, based on similar outcomes, in a non-discriminatory way, paying due respect to home country regulation regimes.” See “Jurisdictions’ Ability to Defer to Each Other’s OTC Derivatives Market Regulatory Regimes,” FSB report to G20 Finance Ministers and Central Bank Governors, 18 September 2014, at www.financialstabilityboard.org/wpcontent/uploads/r_140918.pdf. BIS central bankers’ speeches For instance, Canada and the United States should consider the option of a bilateral agreement on the resolution of banks with cross-border operations in order to clarify responsibilities and enhance co-operation. 24 We have a long history of stable financial and economic integration, and U.S. financial institutions and legal frameworks are similar to ours. If any two jurisdictions could achieve such an agreement, it is Canada and the United States. We could set an example for other countries. In this regard, the 1988 free trade agreement between Canada and the United States offers a useful precedent. It served as a template for other regional agreements at a time when multilateral trade negotiations were making little headway. On cross-border payments, we should come to terms on more efficient arrangements, including harmonizing standards, reducing processing times and establishing direct links between our respective systems. We could, for instance, explore opportunities to enhance the existing FedGlobal program for cross-border payments, which is currently limited to northbound transactions. 25 Conclusion Let me conclude with a few words of wisdom from a great American poet. In his poem “Mending Wall,” Robert Frost questions his neighbour’s belief in the old adage that “good walls make good neighbors.” Instead, Frost writes, before we build a wall we should first consider what we are “walling in or walling out.” The message I take from his words is that good neighbours should work together to build trust, not walls. Canada and the United States have long-established economic and financial ties built on trust that have served both countries well. Today, we have a unique opportunity to advance the global financial reform agenda in the critical, but thorny, areas of bank resolution, OTC derivatives and payments. We both have much to gain by strengthening financial integration between our countries. More efficient cross-border financial services will facilitate more trade. And more trade will contribute to stronger economic growth in both countries. The Canada Deposit Insurance Corporation and the Federal Deposit Insurance Corporation have a memorandum of understanding in place to consult, co-operate and share with each other information on the resolution of cross-border banks. Nonetheless, a more comprehensive bilateral resolution agreement—which builds on the FSB’s ongoing work on cross-border resolution issues, including total loss absorbency and recognition of resolution actions—would reduce uncertainty, increase confidence in the resolution regime and help foster a more integrated banking sector. FedGlobal ACH Payments, which is owned by the Federal Reserve Bank Services, sends cross-border ACH (automated clearing house) credit payments to more than 35 countries in addition to debit payments that are to Canada only. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 15 July 2015.
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Stephen S Poloz: Release of the Monetary Policy Report Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 15 July 2015. * * * Good morning. Senior Deputy Governor Wilkins and I are happy to be here with you again to answer your questions about today’s interest rate announcement, and our latest Monetary Policy Report (MPR). Let me begin with a few remarks around the issues that were most important to the Governing Council’s deliberations. Since our last MPR in April, global economic developments have been quite disappointing, and these have led to a significant downgrade of our estimate of Canadian economic growth for 2015. There were three factors behind this downgrade: First, Canadian oil producers have lowered their long-term outlook for global oil prices, and have cut their plans for investment spending significantly more than previously announced. Second, China’s economy is undergoing a structural transition to slower, domestic-driven growth, which is reducing Canadian exports of a range of other commodities. Third, Canada’s non-resource exports have also faltered in recent months. While this is partly due to the first-quarter setback in the U.S. economy, it’s still a puzzle that merits further study. Given the collapse in oil prices, and declines in some other key non-energy commodities, the economy is now operating on two distinct growth tracks: the resource track and the nonresource track. These tracks are not independent – the cancellation of an investment in the oil patch will often lead to a hit in the manufacturing sector, for example. But we can do some rough decompositions to illustrate the situation. I draw your attention to Chart 18, on page 19 of the MPR. There we can see the sharp drop in oil and gas output, which constitutes 10 per cent of our economy, and the slowdown in non-energy commodity production, which represents a further 8 per cent. The remaining 82 per cent is seeing steady growth, although it has moderated slightly so far this year, due to the setback in the U.S and spillovers from the resource sector. As the non-resource track regains momentum, it is expected to become the dominant trend at the aggregate level. We expected this to begin in the second quarter. But it did not, because of the three factors I listed above. A major shift in a country’s terms-of-trade is one of the most complex situations an economic forecaster can face. We have said from the beginning that while there would be both negative and positive effects from lower oil prices on Canada, the negative effects would dominate, and they would come first. The positives would be more gradual, taking the form of stronger consumer spending, both here and in the U.S., and increased non-resource exports, because of stronger U.S. spending and a lower Canadian dollar. These positives have been slow to emerge, but we can see them working. Export subsectors that are usually sensitive to exchange rate movements have been outperforming. The setback in the U.S. economy appears to have been mainly temporary, as U.S. labour market performance has been strong. In Canada’s non-resource sector, the labour market has been performing well, and our conversations with companies indicate rising capacity constraints. This implies that increased investment and more employment gains are likely in the months ahead. In short, we expect these positive trends to begin to outweigh the negatives coming from the resource sector during the next few months. These considerations figured prominently in the Governing Council’s deliberations, because the state of total demand in the economy relative to our production capacity is what drives BIS central bankers’ speeches our inflation outlook. The economy has been operating below full capacity for some time, which is why we estimate that the underlying trend in inflation is running at around 1.5 per cent to 1.7 per cent. Core inflation is higher than the underlying trend, because a decline in the dollar is raising the prices of imports. Total inflation is much lower, because of past declines in fuel prices. As the temporary effects dissipate, all these measures of inflation will converge on the underlying trend. The weak economic performance in the first half of this year means that Canada has more excess capacity, which is increasing the downward pressure on the underlying trend in inflation. To put it in the language of our risk management framework, the three factors I mentioned earlier moved us out of the neutral zone, to a place where the downside risk to future inflation is material. This would imply a slower return to full economic capacity and sustainable 2 per cent inflation. At the same time, financial stability risks remain elevated. Of particular note are the vulnerabilities associated with household debt and rising housing prices. And we must acknowledge that today’s action could exacerbate these vulnerabilities. However, as we noted in our Financial System Review, financial vulnerabilities would usually translate into full-blown risks – with attendant consequences for the economy – only if there was a trigger, such as a widespread and sharp decline in economic activity and employment. The terms-oftrade shock we are experiencing, which has already translated into an increase in excess capacity and downward pressure on inflation, has the potential to act as such a trigger, if left unaddressed. Accordingly, the Governing Council agreed that acting at this time was consistent both with the Bank’s primary mission – the pursuit of its inflation target – as well as helping to manage financial stability risks, even if there could be some increase in financial vulnerabilities in the process. Let me remind you that monetary policy operates with a long lag and there are many transmission channels through which interest rate changes affect the economy, including longer-term bond yields and the exchange rate. This needs to be taken into account when predicting how the economy will respond to our actions, and when. It also makes it difficult to pin down the precise timing when Canada will reach full capacity with inflation sustainably at target – it could just as easily be sooner as later than projected. Let me also remind you that there are many uncertain elements and risks to our outlook, which are discussed in the MPR. One additional element I could mention is the prospect of interest-rate liftoff in the U.S. Although we have no special insight into when this might occur, we have said many times that it would be welcome, for it would be consistent with a more positive outlook for the U.S. economy. Nevertheless, because the Canadian economy is dealing with a large terms-of-trade shock, it is likely to be less synchronized with the U.S. economy than in the past. Furthermore, we would expect any rises in global bond yields to be at least partly imported into Canada – with possible implications for the Canadian dollar – and with an uncertain net effect on our economy. To conclude, the Canadian economy is undergoing a significant and complex adjustment, even while it is still trying to overcome persistent global headwinds. In the judgment of the Governing Council, today’s action is required to help facilitate the adjustment of the economy to this unusual situation. With that, Carolyn and I would now be happy to take your questions. BIS central bankers’ speeches
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Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, to the Canadian Association for Business Economics, Kingston, Ontario, 25 August 2015.
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Lawrence Schembri: The long-term evolution of house prices – an international perspective Remarks by Mr Lawrence Schembri, Deputy Governor of the Bank of Canada, to the Canadian Association for Business Economics, Kingston, Ontario, 25 August 2015. * * * I would like to thank Don Coletti, Jason Allen, Brian Peterson, Greg Bauer and Denis Gorea for their help preparing this speech. Accompanying charts can be found at the end of the speech or on the Bank of Canada’s website. Introduction Thank you for the invitation to speak here today. Every August since 1961, when John Diefenbaker was prime minister and you could buy a house for $15,000, business and government economists have gathered here in Kingston to discuss issues of the day. CABE has carried on this tradition of convincing economists to attend a conference while everyone else is on vacation. The promise of a good chart is probably all the convincing most of us need. I’ve got plenty of those for you today. I want to talk to you about the evolution of house prices and the underlying determinants of their long-term movements. As you know, developments in the housing sector and the related mortgage market are important, for both the Canadian economy and its financial system. My presentation, then, is part of our ongoing effort at the Bank to promote an informed discussion of housing and house prices. In our quarterly Monetary Policy Report and our biannual Financial System Review we usually take a “here and now” perspective. But today I want to provide more context by stepping back and looking at house prices in two dimensions: • across time, over the past 40 years; and • across countries – in particular, across a group of countries that share economic circumstances and policy frameworks similar to Canada’s. I’ll begin with a quick look at some stylized facts about the evolution of house prices. Then, I’ll examine their long-run determinants from both the demand and supply sides. Finally, I’ll comment on the implications of house prices for financial stability and the recent experience with macroprudential housing-related policies, including their complementary interaction with monetary policy. House price trends Let’s start with trends in house prices. Chart 1 shows indexes of real house prices since 1975 for two sets of advanced economies. Chart 1a shows Canada and a set of comparable small, open economies (Australia, New Zealand, Norway and Sweden) with similar macro policy frameworks and similar experiences during and after the global financial crisis. 1 In particular, they did not have sizable post-crisis corrections in house prices. Although these economies were not at the centre of the crisis, they were severely affected by it and the subsequent recession. They did not experience significant bank failures so the normal channels of mortgage finance continued to operate. Banks in these jurisdictions typically draw on external sources for some of their funding. During the peak of the crisis, these sources largely dried up and banks received temporary liquidity support from public sources. In Canada, for example, the federal government implemented the Insured Mortgage Purchase Program in 2009. BIS central bankers’ speeches For comparison purposes, Chart 1b shows a second set of advanced economies that did experience significant and persistent post-crisis declines in house prices. 2 Three points about these charts. First, there are notable variations across countries. While there is some common movement, local circumstances clearly matter. Second, broadly speaking, real house prices across both sets of countries experienced no material upward trend from 1975 to 1995. Third, a generalized upward movement in house prices began in the second half of the 1990s and is continuing today, even after post-crisis corrections. Real prices remain well above 1995 levels for almost all countries. These trends suggest that there are common factors at the global level or simultaneously in each country that have arisen over the past 20 years and have pushed up real house prices. Understanding these common and idiosyncratic determinants of house prices is important for both macroeconomic outcomes and financial stability and thus the conduct of monetary and macroprudential policies. A framework for analyzing house price trends To analyze these trends, let’s start with some basics. A house is simultaneously both a consumption good and an asset. It delivers a stream of non-financial housing services and, at the same time, is also a store of wealth. For most of us, it is the largest asset we own. A household’s decision to purchase a house depends on the utility of the services it provides, its price, and its ongoing user cost. The user cost includes depreciation, maintenance and interest costs, less the expected price growth. In the housing market, the price is determined by the total demand for housing services and the stock of houses. The equilibrium house price thus depends on the user cost, which includes the expected price appreciation, and this, in turn, depends on the expected evolution of demand and supply factors. To complicate matters, a number of other dimensions influence the choice of the data being analyzed: • Housing can be owner-occupied or rented. • Housing units can be single-family houses or multiple-unit dwellings. • Housing is a composite good consisting of both a structure and land. • Housing prices can be for existing or new houses, or both. For my purposes today, I’ll focus primarily on owner-occupied houses, the total of singles and multiples and the composite price for existing houses measured at the national level. 3 These house price measures are indexes, not levels, rebased from the real house price database of the Federal Reserve Bank of Dallas, with the average of each country’s index for 2005 representing 100. The charts show house price movements for individual countries relative to their average over the period from 1975 to the first quarter of 2015. Because of these multiple dimensions, as well as regional influences within a country, housing and house prices are intrinsically heterogeneous. Therefore, price measures are necessarily indexes. The SP/CaseShiller city-level indexes of repeated sales control for quality, but their availability is limited to a few jurisdictions. In Canada, the equivalent to the Case-Shiller is the Teranet/National Bank Composite House Price Index. The Bank of Canada uses this index and the Canadian Real Estate Association MLS Home Price Index, as well as the MLS average for monitoring purposes. These three price indexes have exhibited the same upward trend. BIS central bankers’ speeches Demand factors Four broad sets of demand factors have likely contributed to rising real house prices across advanced economies since 1995: • macroeconomic – rising disposable incomes and lower long-term interest rates; • demographic – population growth, driven in part by migration, and shifts in age structure and family size; • credit conditions – broader access to and more efficient funding of mortgage credit due to financial liberalization and innovation; and • other factors – improvements to the macro-policy framework, international investment, preference shifts and regulatory and tax changes. House prices and income First, let’s look at house prices and income. Since 1995, house prices in Canada and the set of comparable countries have increased faster than nominal personal disposable income (Chart 2a). 4 During this period, all of these countries experienced solid income growth, with the strongest growth in Norway and Sweden (Chart 2b). During the global financial crisis, these countries also experienced house price corrections. This caused the ratios of house prices to income to decline temporarily, after which they continued climbing. So why did house prices rise faster than income? Demographics There are a number of possible explanations. Consider population growth. Chart 3a shows population growth rates in our set of comparable countries over two periods, 1975 to 1994 and 1995 to 2015. Population growth rates were the highest in Australia, Canada and New Zealand over the entire sample. Moreover, growth rates increased in all countries, except Canada, in the post-1995 period relative to the pre-1995 period. Therefore, population growth could help explain the rise in house prices relative to income for most countries over the latter part of the sample. 5 One of the factors that has affected population growth rates is migration. Net migration was highest in Australia and Canada over the entire sample. In addition, net migration increased importantly in all five countries in the second half of the sample period (Chart 3b). 6 In Australia, Canada and New Zealand, the rate of population growth of the approximate house-owning cohort of those aged 25 to 75 declined in the second part of the sample period. This likely reflects the aging of their populations as the postwar baby boom generation moved from youth into middle age (Chart 4). Nonetheless, the growth rate of this cohort still remains well above 1 per cent for these three countries. Nominal personal disposable income was rebased to be consistent with the rebased house prices in each country, as described in footnote 2. Sweden had the lowest rate of population growth among these countries, but it also experienced the largest increase in real house prices between 1995 and 2015. The home-ownership rate of immigrants is slightly less than that of native-born residents in all five countries. “Indicators of Immigrant Integration: Settling In,” OECD Publishing, 2 July 2015, p. 179. BIS central bankers’ speeches In Canada, it is noteworthy that the average family size decreased from about 3.5 in 1976 to below 3.0 in 2011, a decline of approximately 20 per cent. 7 Partial evidence suggests that this pattern is similar in the other advanced economies in our sample. This decline in the average family size has supported the rate of household formation, and thus, has partially offset the impact of the lower growth rate of the house-owning cohort on the demand for houses in Australia, Canada and New Zealand. 8 It is also important to consider where population growth is occurring. Chart 5 shows that over our sample period, the pace of urbanization, measured by the change in the urbanization ratio, has increased since 1995 in all of the countries in the comparable group, except New Zealand. 9 Australia and Canada are notable for the size of the shift, which could be explained by a number of factors. These include the well-known agglomeration economies of scale provided by urban areas and the location preferences of home-owners, especially younger-age cohorts and recent immigrants. 10 The urbanization of the population in Norway also stands out. This could potentially explain why house prices have grown faster in Norway than in Canada, even though population growth in Canada has been higher than in Norway. To sum up, population growth and the shift in demand for housing toward urban areas have exerted strong upward pressure on house prices. Credit conditions A third demand factor affecting house prices is the improvement in mortgage credit conditions. Lower long-term interest rates and financial liberalization and innovation have improved housing affordability in advanced economies, especially since the mid-1990s. I’ll say a few words about each of these changes that have influenced the availability of credit. Since 2000, real 10-year government bond yields have trended downward across all advanced countries, including those in our comparison group, with a slight increase during the recent financial crisis (Chart 6). The decline in yields has been attributed to higher global savings and stronger monetary and fiscal policy frameworks, which have credibly reduced inflation and risk premiums by increasing macroeconomic stability in the roughly 15-year period (known as the Great Moderation) that preceded the global financial crisis. 11 Since the crisis, persistently weak global demand – especially real investment – coupled with sustained low central bank policy rates and large asset purchases has helped to lower long-term interest rates and, in turn, reduce financing costs for financial intermediaries and mortgage rates for households. 12 Other things being equal, this decline has helped improve the affordability of home ownership and support demand for houses. “Fifty years of families in Canada: 1961 to 2011,” Statistics Canada. In Canada, the evidence indicates that much of the increase in home ownership is among the older cohort of the population, which suggests that longer and healthier life spans may have supported house demand in recent years. For example, the urbanization ratio in Canada increased from 75.61 per cent in 1975 to 77.68 per cent in 1995 and 81.65 per cent in 2014. New Zealand is the most urbanized country in the sample; its ratio was already above 80 per cent in 1975. See, for example, Agglomeration Economics, edited by Edward L. Glaeser, National Bureau of Economic Research Conference Report (Chicago: University of Chicago Press, 2010). For more on the decline in real long-term interest rates, see C. Wilkins, “Monetary Policy and the Underwhelming Recovery” (speech to the CFA Society, Toronto, 22 September 2014). For example, in Canada discounted 5-year mortgage rates have declined by about 470 basis points since 2000, from just above 7.25 per cent to 2.55 per cent. BIS central bankers’ speeches Credit conditions have been positively affected by financial liberalization and innovation. Recent work by the International Monetary Fund has catalogued the related effects of these two factors on access to housing market finance and mortgage market development across countries. 13 The trend in advanced economies from the mid-1990s until the crisis has been toward higher maximum loan-to-value ratios, longer amortizations for mortgage borrowers and more flexible funding arrangements for mortgage lenders in terms of covered bonds and mortgage securitization. The assessment and diversification of mortgage credit risk have also improved. As a consequence, a broader set of borrowers and lenders has become involved in obtaining and providing mortgage finance. Chart 7a shows a positive relationship between a summary index of mortgage finance conditions, constructed by the IMF, which captures both financial liberalization and innovation, and the depth of the mortgage markets across several advanced economies. 14 Although data for New Zealand are not available, the chart indicates that the other four countries in our comparison group have mortgage finance conditions in place that generate deep mortgage markets and foster broad and often less procyclical access to mortgage finance. Again, other things equal, this supports demand for owner-occupied housing and higher house prices. Chart 7b shows that home-ownership rates in Canada and Sweden (over a shorter sample period) have risen, suggesting that these changes to mortgage finance have had a positive impact on housing affordability. In Australia, the rate of home ownership has declined. This may be due to a more modest change in mortgage credit conditions. Or, more likely, affordability has been eroded by rapidly rising house prices, which have increased the most in Australia among the comparison group. For Norway, there has been no material change in the home-ownership rate over this limited time period. 15 As I noted earlier, important innovations have fostered deeper, more efficient and diversified mortgage financing. I’ll comment on the two most significant: covered bonds and securitization. Covered bonds have been popular in Denmark for a long time. They were introduced and have become more widely used in Sweden and Norway and, to a lesser extent, in Canada, Australia and New Zealand (Chart 8a). These bonds have played a growing role in mortgage finance in the post-crisis period because they are generally viewed as safer than private-label securitization. They give investors access to dual collateral: the mortgages securing the bonds as well as other assets on the issuer’s balance sheet should the mortgages prove insufficient. 16 Securitization of mortgages also increased significantly in the pre-crisis period in some countries, especially private-label securitization in the United States (Chart 8b). While these vehicles were successful in raising large amounts of mortgage funding before the crisis, they were an important source of financial vulnerability during the crisis because the incentives to originate and securitize subprime mortgages were misaligned and the related risks were opaque and not well priced. See International Monetary Fund “Housing and the Business Cycle” in World Economic Outlook, April 2008; and E. Cerutti, J. Dagher and G. Dell’Ariccia “Housing Finance and Real-Estate Booms: A Cross-Country Perspective,” IMF Staff Discussion Note, June 2015. See International Monetary Fund “Housing and the Business Cycle” in World Economic Outlook, April 2008. Comparable time-series data for New Zealand are not available. Since covered bonds are relatively senior in the creditor hierarchy in the event of insolvency, they have a preferential claim over depositors and other debt-holders. BIS central bankers’ speeches Since the crisis, we have seen a dramatic decline in private-label securitizations of residential mortgages, which has not recovered, despite global financial reform efforts led by the G-20 to address the serious weaknesses in their design. Publicly supported securitization has continued to play an important role in funding residential mortgages over this period, however, especially in the United States and Canada. Other factors supporting demand A number of other related factors have likely supported the demand for houses in our comparison group and in advanced economies more generally. All of the countries in our comparison group had solid macro and financial policies characterized by • monetary policy frameworks comprising explicit and credible inflation targets and flexible exchange rates; • sustainable fiscal positions; and • effective financial regulatory and supervisory frameworks. 17 As a result, these countries achieved a high degree of macro and financial stability over the post-1995 period; in particular, they kept inflation low. This stability had a number of important consequences. It reduced uncertainty for households and firms. As noted, it also lowered risk premiums and long-term interest rates. 18 And it fostered financial and mortgage market development. These countries all coped with the crisis and its aftermath relatively well. Economic and financial stability strengthened the demand for houses because it enhanced the perception that they are safe, high-quality assets. 19 Consequently, households may have decided to shift more of their wealth into housing and consume more housing services as their income increased by buying more owner-occupied dwellings over time. This trend was supported by government policies (although not widespread in our comparison group) to promote home ownership, especially for younger and lower income households. 20 Supply factors Now let’s look at the supply factors that have influenced the prices of houses, in particular, regulation and geography. Such supply constraints tend to be most binding in urban areas. Coupled with the observed shift in demand related to population growth in urban areas, supply constraints may have put significant upward pressure on house prices in urban areas in advanced economies. All of the countries, except Sweden, are significant commodity exporters. From 2002 until 2014 they benefited from rising commodity prices. Credibly reducing expected inflation also contributes to lower nominal mortgage rates. The effect of this is to spread the real burden of servicing a mortgage more evenly over its term. Foreign investors also perceived these countries as attractive locations to invest in real estate, although the impact of their investment on house demand and prices in the countries is unlikely to be widespread. A recent survey of international real estate investors found that Australia, Canada, Sweden and several other countries represent the “most stable and secure” environments for real estate investment. (See Foreign Investment Survey, Association of Foreign Investors in Real Estate, January 2013.) The IMF, in a review of existing – albeit scarce – evidence, concluded that the impact of foreign investors on real estate prices is not pervasive, but is limited to certain urban markets and at higher price ranges. (See H. Ahir, H. Kang and P. Loungani, Seven Questions on the Global Housing Markets, IMF Research Bulletin, September 2014. Examples of such policies include favourable tax treatment (mortgage interest deductibility, reduced capital gains, tax deferred home-ownership savings programs) and public mortgage guarantees. BIS central bankers’ speeches The regulatory factors include land-use or zoning restrictions that specify, for example, minimum lot sizes or maximum development density; the establishment of greenbelts around urban areas, which represent a more sweeping land-use restriction; and development fees. In terms of geographical constraints, the most common are bodies of water and landscape features such as mountains, wetlands and other terrain not suitable for residential development. To what extent are these sorts of constraints affecting house prices in urban areas? Chart 9 provides some suggestive evidence on the impact of land-use regulations on median priceto-income ratios. Many of the cities with higher ratios also have obvious geographical constraints – Hong Kong and Vancouver are good examples – so the two sources of supply restrictions likely interact to put upward pressure on prices. To examine the implications of these supply constraints, it is useful to consider the impact of urban population density on house prices. Chart 10 indicates that, over the period from 1995 to 2014, there was a strong positive relationship between increases in population density and house prices in Canadian urban centres. 21, 22 Greater population density, combined with regulatory and geographical constraints, creates price incentives that cause shifts in the available housing mix. 23 In particular, as the prices of single-family homes rise, condos become a more affordable alternative. In Vancouver, bounded on three sides by water with coastal mountains as a backdrop, condo development has dominated housing starts since the early 1990s. We are now seeing a similar shift to condos in Montréal and Toronto (Chart 11). 24 In recent years, Toronto and Vancouver have seen price growth in single-family houses outpace multiples (mainly condos) by a factor of two to three. About a third of the Canadian housing stock is in Toronto, Montréal and Vancouver so this change is significant. Outside of Canada’s big three cities, condos are only now becoming as important as single-family homes. Given these supply constraints, the increasing urbanization of Canada’s population is putting upward pressure on Canadian house prices. Policy implications In view of these demand and supply factors, which have tended to work together to cause house prices to rise faster than income since 1995 in advanced countries, especially in urban areas, what are the implications for monetary policy and, perhaps more importantly, for financial stability policy? Given recent rises in house price, the increase for Vancouver shown in Chart 10 is lower than might be expected because the starting point of the sample (1995) was a significant peak for prices in Vancouver. House prices shot up 34 per cent from 1990 to1995 while other Canadian cities had either negative or minimal growth of less than 10 per cent. From 1995–2005, house prices in Vancouver rose by 48 per cent, but that was outpaced by price increases in other Canadian cities that ranged from 65 to almost 140 per cent. Winnipeg’s decline in population density is, in part, due to a 30 per cent increase in its municipal boundaries over this period. This relationship is also true for U.S. cities. See “Urbanization & Canadian REITs,” CIBC Institutional Equity Research Industry Update, April 2012. As cities grow, the price of housing in the urban core typically rises faster than in the periphery. This steepening of the “rent curve” reflects the agglomeration economies as well as the higher opportunity cost of commuting. See D. Capozza and L. Helsey, “The Fundamentals of Land Prices and Urban Growth,” Journal of Urban Economics, 26, no. 3 (1989): 295–306. City authorities have also encouraged condo development to achieve higher densities in certain areas and control infrastructure costs. BIS central bankers’ speeches The advanced economies in our comparison group had similar experiences during and after the global financial crisis. They suffered sizable declines in exports to their major trading partners that were more severely affected by the crisis. Their domestic financial institutions and markets were adversely affected by spillovers from global financial stresses. Liquidity and credit conditions tightened severely. In response, they loosened monetary policy, with sharp declines in policy interest rates. Their credible inflation-targeting frameworks, flexible exchange rates and resilient financial systems meant that such countercyclical monetary policy easing was effectively transmitted into lower real interest rates along the maturity spectrum. This easing supported the economic recovery by boosting domestic demand, notably in sectors sensitive to interest rates, such as housing, and caused house prices to recover from declines experienced during the crisis. But, to date, the global recovery has been weak, so global and domestic interest rates have remained at historically low levels. This has underpinned the demand for, and the prices of, houses in the post-crisis period. Since elevated house prices have important implications for financial stability, the Bank of Canada is closely monitoring the housing market. In particular, as we noted in recent issues of our Financial System Review, rising house prices contribute to two material vulnerabilities that can affect financial stability: 1. Higher house prices are generally associated with higher levels of household indebtedness and leverage. 25 2. Higher house prices represent a potential source of asset-price misalignment if influenced by expectations of price appreciation not consistent with evolving fundamentals. 26 Such misalignment could suddenly correct and create financial stress. 27 The likely trigger for both vulnerabilities would be a major global shock that generated a sharp increase in unemployment and possibly in interest rates as well. If these vulnerabilities were triggered, the adverse impact on the financial system and the economy would be amplified by the exposure of banks and other intermediaries to them. Now, when we look at the post-crisis experiences of the countries in our comparison group, they have similar levels of household leverage, measured by household debt as a ratio of GDP (Chart 12). 28 Household leverage has risen along with house prices, as households have taken advantage of low post-crisis interest rates. The one exception is New Zealand, where a modest degree of household deleveraging seems to have occurred. For Canada, the ratio of household debt to GDP has risen since 1975, although the growth of this ratio has notably declined since 2010. For Sweden and Norway, the ratio also grew at a modest pace in the post-crisis period. 29 See, for example, A. Crawford and H. Faruqui “What Explains Trends in Household Debt in Canada?” Bank of Canada Review (Winter 2011–12): 3–15. Extrapolative house price expectations may arise during periods of strong house price growth driven by shifts in demand and supply factors. See E. Cerutti, J. Dagher and G. Dell’Ariccia “Housing Finance and Real-Estate Booms: A Cross-Country Perspective,” IMF Staff Discussion Note, June 2015. The December 2014 and June 2015 issues of the Financial System Review examine various estimates of the degree of overvaluation of Canadian houses. The household debt-to-GDP ratio is more consistently measured across countries than the household debt-todisposable income ratio and is thus more useful for comparison purposes. While the significant reductions in interest rates in the immediate aftermath of the financial crisis increased house affordability in these countries, this gain has been offset by the ongoing increases in house prices. For BIS central bankers’ speeches The inflections in the rate of leverage growth that we see in the chart after the crisis may be due to the macroprudential measures these countries implemented. Such measures have allowed stimulative monetary policy to flow through to households with the capacity to borrow. 30 Chart 13a and b draw on recent work by the IMF, which shows that macroprudential policies in the form of maximum loan-to-value (LTV) or debt-to-income (DTI) ratios have tightened across a broad range of countries over the past 10 years. 31 The IMF’s research, as well as that of other economists, has found evidence suggesting that the tightening has helped to: • reduce the procyclicality of household credit and bank leverage; • moderate credit growth; • improve the creditworthiness of borrowers; and • lower the rate of house price growth. The most effective macroprudential policies to date appear to have been the imposition of maximum LTV and DTI constraints. 32 Increased capital weights on bank holdings of mortgages have also had an impact. 33 While long-term evidence on these instruments is not yet available, permanent measures that address structural regulatory weaknesses and that are relatively straightforward to implement and supervise will likely be the most effective over time. In Canada, we have had four successive rounds of macroprudential tightening, primarily in terms of the rules for insured mortgages (Figure 1). I’ll mention just a few of the highlights. The maximum amortization period for insured loans has been shortened from 40 years to 25. 34 LTV ratios have been lowered to 95 per cent for new mortgages, and 80 per cent for refinancing and investor properties. These latter two changes effectively eliminate new insurance for refinancing and investor properties. Qualification criteria such as limits on the total debt-service ratio and the gross debt-service ratio, as well as requirements for qualifying interest rates, have also been tightened. 35 Recent evidence suggests that these measures have resulted in higher average credit scores, which have improved the quality of mortgage borrowing (Chart 14a). With respect to household credit growth, Chart 14b, shows that the trend growth of mortgage credit declined example, Chart 6 in the December 2014 Financial System Review shows that the affordability of houses in Canada has been relatively unchanged since 2008. Evidence in “Debt and (Not Much) Deleveraging” (McKinsey Global Institute, February 2015) suggests that much of the debt in countries in the comparison group is held by relatively high-income households. E. Cerutti, S. Claessens, and L. Laeven, “The Use and Effectiveness of Macroprudential Policies: New Evidence,” IMF Working Paper WP/15/61, March 2015. Ibid. Mortgage underwriting standards have also been tightened recently in many countries, as they have implemented the Financial Stability Board’s Principles for Sound Residential Mortgage Underwriting Practices, April 2012. Uninsured mortgages are still available with longer amortizations; the normal maximum is 30 years. The total debt-service ratio is the percentage of gross annual income required to cover annual payments associated with housing and all other debt obligations. The gross debt-service ratio includes only housingrelated payments. Other changes to insured mortgages include a minimum credit score, with limited exceptions; stronger loan documentation standards to ensure the reasonableness of the property value and of the borrower’s sources and level of income; mortgage insurance eliminated for non-amortizing home-equity lines of credit; and mortgage insurance now limited to homes with a purchase price of less than $1 million. In addition, mortgage and mortgage insurance underwriting principles have been made consistent with international standards. See Guidelines B-20 and B-21issued by the Office of the Superintendent of Financial Institution. BIS central bankers’ speeches from 14 per cent in 2007–08 (3-month growth, annualized) to around 5 per cent in 2013–15. 36 Conclusion Let me conclude with a few key points from the mountain of facts, graphs and analysis that I have reviewed with you today. As I mentioned at the outset, the purpose of my presentation is to help provide more context for an informed discussion about housing and house prices given their importance to the Canadian economy and the financial system. First, real house prices have been rising relative to income in Canada and other comparable countries for about 20 years. There are many possible explanations, mostly from the demand side, but also from the supply side. Second, in terms of demand, demographic forces, notably migration and urbanization, have played a role in the evolution of house prices, as have improving credit conditions through lower global real long-term interest rates and financial liberalization and innovation. There are, of course, other demand factors that warrant more data and analysis, including the impacts of foreign investment and possible preference shifts. Third, in terms of supply, the constraints imposed by geography and regulation have decreased housing supply elasticity, especially in urban areas. This reduced supply elasticity has interacted with demand shifts toward more urbanization to push up house prices in major cities. Fourth, the credible and effective macro and financial policy frameworks in place in Canada and the other countries considered here have contributed to a high degree of macroeconomic and financial stability. Consequently, in the face of a protracted global recovery, their countercyclical policies successfully underpinned domestic demand in the post-crisis period. The resulting strength in the housing market has increased household imbalances, but the risks stemming from these vulnerabilities have been well managed by complementary macroprudential policies. The experience in these countries therefore suggests that macroprudential policies that address structural weaknesses in the regulatory framework are best suited for mitigating such financial vulnerabilities. They reduce tail risks to financial stability and enhance the overall resilience of the financial system. Thank you. Enjoy these last few days of summer. Other factors also influenced the growth of mortgage credit over this period. In particular, note that in late 2008–09 the Canadian economy was in a recession. The decline in that period should not be interpreted as a result of the first wave of tightening of the mortgage rules. Similar evidence on the impact of these macroprudential policies is found by I. Krznar and J. Morsink, “With Great Power Comes Great Responsibility: Macroprudential Tools at Work in Canada,” IMF Working Paper WP/14/83, May 2014. 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 Stephen S Poloz, Governor of the Bank of Canada, to Calgary Economic Development, Calgary, Alberta, 21 September 2015.
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Stephen S Poloz: Riding the commodity cycle – resources and the Canadian economy Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to Calgary Economic Development, Calgary, Alberta, 21 September 2015. * * * I would like to thank Bahattin Buyuksahin, Brigitte Desroches, Kun Mo and Konrad Zmitrowicz for their help in preparing this speech. Introduction This isn’t the first time that a governor of the Bank of Canada has come to Calgary to talk about commodities. I suspect it won’t be the last. It’s an obvious discussion topic here in Alberta, where resources make up more than a quarter of the economy. Of course, such riches aren’t unique to Alberta. Natural resources have been a big economic story for this country since the time of European contact. Today, Canada is the only major exporter of natural resources among the G-7 nations. Oil is just one part of the story – we are also a major producer and exporter of coal and natural gas, base and precious metals, minerals such as potash, and agricultural and forest products. Because Canada has been endowed with such a wide variety of resources, we’ve had to learn how to deal with large swings in their prices. I don’t just mean the usual high degree of volatility common among many raw materials. I’m also referring to the long-term swings in prices that are often called “super cycles.” What’s important to remember is that these longterm swings are driven by the fundamental economic laws of supply and demand, as well as the continuous technological progress that can affect both output and consumption. The pattern is familiar. A large and persistent increase in demand leads to sustained upward pressure on resource prices over a number of years. The higher prices act as an incentive to boost supply, and companies act by, for example, investing in new capacity and finding methods to increase efficiency. While high prices can certainly spur research and development, technological progress has been a constant theme in natural resource industries. Such advances uncover ways to raise output and lower production costs. And it’s because of this progress that inflation-adjusted commodity prices have generally been trending lower for 200 years. The investments that lead to increased output can take years, if not decades, to complete. But, over time, the higher output generated by those investments combines with stabilizing demand to bring about a period of downward pressure on prices. Faced with lower prices, companies may scale back investment and production. Ultimately, the lower prices will encourage demand, and the reduced investment will crimp future supply, leading to higher prices. And producers will ride the price cycle all over again. Any economy that relies on natural resources will naturally be challenged by large movements in their prices. These shocks are more than just swings in national income; they also force businesses to make decisions about the way resources such as capital and labour are allocated. These decisions often lead to difficult adjustments, but they are necessary for maximizing our economy’s potential. While an abundance of raw materials may complicate the management of companies and the conduct of economic policy, it’s far better for a country to have resources than not to have them. Even when prices are falling, as they have been recently, our endowment represents a store of value and a source of future riches. What I’ll do in the rest of my time today is talk about some of the global forces that have been driving recent swings in commodity prices and look at how they may evolve in the years to BIS central bankers’ speeches come. Then, to emphasize just how uncertain the outlook can be, I’ll talk about some alternative scenarios that could dramatically alter the future for producers. Finally, I’ll revisit some of the lessons that policy-makers and business leaders can apply today and in the future. Global forces at work Let’s take a look back at resource prices over the past 15 years or so. We saw a large and persistent increase in demand, sparked by rapid economic growth in emerging markets. In China, the world’s most populous country, economic growth averaged about 10 per cent annually between 2001 and 2011, a period that included the global financial crisis. Chinese growth has meant enormous demand and rising prices for many of Canada’s resources, particularly coal and oil, as well as base metals such as copper, nickel and aluminum. As millions of people in emerging markets left rural areas for cities, demand increased for building materials such as the iron ore used in steel, and this supported prices. Although the financial crisis led to price declines, many raw materials rebounded sharply. By April 2011, the Bank of Canada’s commodity price index had reached its post-crisis peak. However, rapid growth tends to moderate as an expansion matures. Chinese economic growth has eased to an average of 7.5 per cent since 2012, as authorities have tried to engineer a more sustainable and domestically oriented expansion. Similarly, India, which saw annual GDP growth near 9 per cent from 2005 to 2010, has also moderated since 2012. While it’s true that these cooling growth rates have had an impact on prices, we shouldn’t forget that emerging markets are still an important source of demand. Indeed, since the start of the decade, the Chinese economy, now the world’s second-largest, has more than doubled in size when measured in current dollars. In terms of supply, we’ve also seen responses that are putting downward pressure on prices for metals and some energy goods. For example, the iron ore supply continues to expand despite lower prices, thanks to the impact of multi-year investments made when prices were higher. These investments led to expanded capacity in low-cost areas such as Australia and Brazil. Now let me say a few words about oil prices. This topic is obviously of great importance here in Alberta because of its impact on employment and the overall economy. But it’s also important for Canada as a whole, given the implications for national income and interprovincial trade, as well as the industry’s sizable influence on business investment. Why did oil prices fall so much? The main reason is that supply rose sharply, thanks primarily to technological advances in oil extraction everywhere. This includes the oil sands, tight oil and the Bakken deposits. Consider in particular the technological progress that enabled producers to tap tight oil reserves. Output from the United States alone, which essentially didn’t exist before 2008, reached 4.2 million barrels per day last year. That increase is roughly equivalent to all the oil that Canada produces in a year. Given the dramatic drop in prices over the past year, the Bank has spent a lot of time speaking with business leaders to try to gauge precisely how they will react. At the start of the year, oil companies were saying that they intended to cut investment by about 30 per cent. Prices didn’t recover as much as was forecast at the time, so companies subsequently told us that they would cut their investment intentions by about 40 per cent. Currently, based on discussions I’ve had over the past couple of weeks, many firms are still revising their longer-term expectations for oil prices. The Bank will continue to assess what the impact may be on their investment spending. What this means for the evolution of oil prices is very hard to say. The Bank’s usual practice is to assume for our projection that oil prices will remain stable and use our economic models to test alternative scenarios. I know many companies do the same. But that can be risky: BIS central bankers’ speeches because the vast majority of oil transactions are financial, rather than between producers and users, prices tend to be more volatile than the underlying fundamentals. Before I move on, let me emphasize a point. Lower prices for base metals and oil today do not mean that long-term investments, which may take years to complete and last for decades, were somehow a mistake. Without those investments, we would never have been able to capitalize on the higher prices, which boosted Canada’s aggregate income. What matters for a given investment is how prices evolve over the life of the project, which is impossible to know when long-term investment decisions must be made. From the end of 2008 to the end of 2010, the price of copper tripled, while oil and nickel prices more than doubled. If you believe in market forces, these movements represented a clear signal to invest and expand output. Those who were able to recognize the opportunity, make adjustments and exploit the higher prices were rewarded, and the increased income brought important benefits to Canada’s economy. Alternative scenarios and the need for flexibility Now let me spend some time talking about the future. The price cycle I’ve sketched out may appear to be fairly predictable. But history has repeatedly shown that new technologies can quickly upend assumptions about future demand and supply. For example, back in the 1970s, there were predictions that the world would run out of copper by the end of the century. The people who made that forecast did not foresee that copper wire, long a staple of communications infrastructure, would be replaced by fibre-optic cable, with its glass threads made from silica. This technology helped reduce the demand for copper, in essence extending its supply. Similarly, digital photography had a dramatic impact on the photo-processing industry. Twenty years ago, the idea that everyone would carry around telephones that were also good-quality cameras was ridiculous. People took pictures with cameras that were loaded with film and took the film to a developer. The processing consumed a lot of silver. Back then, if you didn’t anticipate the emergence of digital photography, you might have expected this source of demand would continue indefinitely. Instead, according to the Washingtonbased Silver Institute, the use of silver in photography peaked in 1999 and has fallen by almost 80 per cent since. It’s these sorts of technological advances that make predictions about future demand and supply so difficult. But it’s also these technological advances, combined with Canada’s many gifts of natural resources, that will generate the opportunities to secure our future prosperity. Our goods will remain in demand; we will continue to have lumber for houses, metals for industrial production and oil for use in plastics – and it’s hard to imagine that Canadian roads won’t continue to need new asphalt repairs. Further, it’s important to remember that Canada’s endowment is extremely diverse. While the cycles for base metals and oil have turned lower, there is still substantial demand that’s supporting the prices of many agricultural goods. As I noted, with continued growth in emerging markets, their populations are becoming increasingly urbanized. In North America, 82 per cent of the population lives in urban areas. That compares with 55 per cent in China, and just 30 per cent in other emerging markets such as India. This trend toward urbanization is likely to continue. With it will come growing demand for goods linked to household consumption – particularly agricultural products. Consider the hundreds of millions of people who are climbing the income scale in India and China. Their changing diet implies much more than just stronger demand for traditional protein sources. It also implies demand for inputs such as fertilizer, animal feed, fish feed, oilseeds and specialty crops such as lentils and chickpeas. Indeed, the latest traffic figures from Port Metro Vancouver show sharp growth in shipments of wheat and specialty crops, and solid gains in meat, poultry and potash. BIS central bankers’ speeches Canada is particularly well placed to tap growing demand for fish and other seafood. Canadian seafood exports to China in the first half of the year grew by 11 per cent compared with the same period last year. To take just one example, 60,000 lobsters are flown from Halifax to Shanghai every week, aided by advances in shipping and production technology. Thanks in part to this demand, lobster prices have been rising sharply. In terms of aquaculture, however, there appears to be considerable growth potential. While mussel farming output grew by about 35 per cent from 2009 to 2013, farmed salmon production plateaued over that period at about 100,000 tonnes a year. Canada has more coastline than any other country in the world. Yet the volume of our seafood output is dwarfed by countries such as Norway, which produces seven times as much as Canada does. I’ll leave it to others to figure out how best to tap this potential resource. Rare earth minerals, the 17 elements used in high-tech products such as cell phones and hybrid vehicles, represent another potential source of growth for Canadians over time. It’s impossible to know with certainty where opportunities will emerge 30 years from now. What new technological advances lie just over the horizon? Consider, for example, the future of water desalination. Right now, the process of removing salt from sea water is too energyintensive to be economically feasible on a large scale. But perhaps we are just one technological breakthrough away from solving this problem. Imagine the impact if the chronic droughts plaguing western North America and Australia could be eased by desalinated ocean water. The point of this exercise is to emphasize just how uncertain the future is. Businesses, consumers, governments – we must all plan for the future based on the best information we have. At the same time, natural uncertainty requires us to be flexible to adapt to circumstances that can change rapidly. In concrete terms, this means business leaders must be aware of the risks involved in resource production, manage those risks as best as they can, and be ready to react to market signals and seize opportunities. History has shown that the companies that are nimble are the ones that are best poised to thrive over time. Policy-makers can help in these efforts by encouraging economic flexibility. This means allowing the necessary adjustments to take place and not frustrating flows of investment or labour from one region to another. Canada’s labour market showed impressive flexibility when oil prices were rising, as workers flocked to Alberta to fill demand. And, in our latest Business Outlook Survey, the Bank saw evidence of labour shortages easing in regions where some interprovincial workers are returning from the oil patch. Policy lessons Before I conclude, let me say a few words about how monetary policy fits into the picture. There are lessons that we can take from previous price cycles. The most important of these is the value of our monetary policy framework. We can’t do much about resource price shocks. But our policy can help the economy adjust to them. In particular, our floating exchange rate helps absorb some of the impact of the price movements and sends signals that facilitate adjustments. Think back to the previous decade. From 2002 to 2012, oil prices went from about US$25 per barrel to more than US$100 per barrel, leading to a jump in our national income. Over the same period, the Canadian dollar appreciated from a record low of around 62 cents U.S. to above parity, helping to reduce the inflationary risks that came with the stronger growth and increased income. Similarly, over the past year, both oil prices and the Canadian dollar have fallen sharply. The floating currency is helping to reduce the disinflationary risks that have come with the cut in our national income. Further, allowing the currency to float frees the Bank of Canada to concentrate our single policy tool on our single target, which is inflation. If we tried to offset BIS central bankers’ speeches these currency movements, we would end up frustrating the natural shifts in economic resources. By focusing on our mandate to keep inflation low, stable and predictable, the Bank has built up credibility, and Canadians have well-anchored inflation expectations, even in the face of large price swings. For example, when we have seen big moves in energy costs, such as the price of gasoline, there has been little evidence that consumers began to adjust their overall inflation expectations, either upward or downward. Why is this important? Since Canadians see our commitment to our target as credible, that makes it much easier for us to reach our mandated goal without needing big swings in output or interest rates. Those of you who can recall our experience with the oil price shock of the 1970s will remember the subsequent effort required to bring inflation under control. Without a credible target and with unanchored expectations, inflation soared. Extremely high interest rates were needed to get price increases back under control. Another point to remember is that swings in commodity prices can affect the normal relationship between the total inflation rate and the core measure of inflation that we use as an operational guide. For example, total inflation is currently being pushed down by the impact of lower energy costs. In contrast, core inflation, which strips out the most volatile inflation components, is facing upward pressure because recent declines in the exchange rate are boosting the prices of imported goods. However, we expect these to be one-off effects, and, as such, we would look through them. As we noted in our July Monetary Policy Report, when all the temporary factors are stripped out, the underlying trend in inflation in Canada is in the range of 1.5 per cent to 1.7 per cent, below our target of 2 per cent. Given these complications, the Bank is looking at how we measure core inflation as part of our regular review of our inflation-targeting regime. Next year, we will answer the question of whether the Bank should continue to focus on one pre-eminent measure of core inflation and, if so, whether our current core measure will remain in that role. In our interest rate announcement earlier this month, the Bank noted that the resource sector is continuing to adjust to lower prices, and that these complex adjustments will take considerable time. Our inflation-targeting regime will help facilitate these adjustments. Canada has seen this movie before – we’ve managed it well in the past, and I’m confident we will continue to manage it well in the future. Conclusion It’s time to conclude. As Albertans know well, it can be hard to ride the cycles in raw materials prices. But resource price fluctuations affect all countries, whether they are consumers or producers. Canada is fortunate to be both, and we shouldn’t ignore the resources that we have been blessed with. Natural resources bring opportunities. Over the years, Canadians have used our endowment to build a prosperous economy. We will continue to do so. And rather than resist market forces, Canadians should heed the signals sent by price movements. We’ve adjusted to rising prices; we can adjust to falling ones. These adjustments are never easy. They are often difficult and painful for affected individuals and their families. But they are necessary. For our part, the Bank of Canada will continue to promote low, stable and predictable inflation. Doing so is the best contribution we can make to helping promote both strong, steady economic growth and the flexibility needed to ease those adjustments and help our resource-rich country thrive. BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, at the 2015 Institute of International Finance Annual Membership Meeting, Lima, 10 October 2015.
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Stephen S Poloz: Integrating financial stability into monetary policy Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, at the 2015 Institute of International Finance Annual Membership Meeting, Lima, 10 October 2015. * * * I would like to thank Don Coletti and Stephen Murchison for their help in preparing this speech. Introduction The experience of the global financial crisis and subsequent Great Recession has led policymakers to question some basic assumptions. Long-held beliefs about monetary policy no longer apply in today’s global environment. Ten years ago, the idea that focusing on price stability could actually contribute to the buildup of dangerous imbalances was very much a minority view. Central bankers now understand that financial stability issues must somehow be integrated into the conduct of monetary policy. And both central bankers and leaders of financial institutions are working to understand the impact of the sweeping regulatory reform agenda that is being implemented. Around the world, researchers are looking at the issues from several angles. How are financial system reforms affecting monetary policy? How can different monetary policy choices affect financial stability? Today, the idea that central bankers should pay little heed to stability issues and simply “stick to our knitting” of inflation control, a position once advocated by many, seems quaintly naïve. Through painful experience, we have been reminded that a well-functioning financial system is critical for economic activity and the transmission of monetary policy. We saw the emergence of excessive risk taking, aided by financial engineering and shortcomings of oversight, during an extended period of low and stable inflation and low volatility. The crisis showed us how financial imbalances in one sector of one economy could be amplified and propagated across the entire financial system, leading to the worst global downturn since the Great Depression. So what I will discuss today is how central banks integrate financial stability concerns into the pursuit of our goals of price stability and macroeconomic stabilization. This exercise is fraught with risks and uncertainties and it is complicated by the fact that macroeconomic and financial stability objectives are not always consistent with each other. Coping with this becomes a problem not of policy optimization, but of risk management. In other words, we put aside the idea of engineering the perfect policy and focus instead on the more realistic goal of finding an appropriate policy setting, given the risks and uncertainties. Monetary policy and financial imbalances The debate about using monetary policy to respond to financial imbalances has evolved rapidly since the pre-crisis era. A decade or so ago, the discussion was essentially between those who argued that monetary authorities should lean against imbalances such as assetprice bubbles and those who said that monetary policy should be reserved for cleaning up the mess after the bubble popped. Before the financial crisis, the Bank of Canada basically straddled the two camps. On the one hand, we argued that it’s very difficult to identify an asset-price bubble, and central bankers have no comparative advantage in making this determination. Like many, we questioned the wisdom of using the blunt instrument of interest rates on a bubble that could be confined to one asset class. Indeed, if a bubble was particularly large and persistent, a central bank that used the cure of higher interest rates could end up causing the very economic damage it was trying to prevent. BIS central bankers’ speeches On the other hand, the Bank recognized that price stability was a necessary, but not sufficient, condition for financial stability. Given our keen interest in a well-functioning financial system and our macro perspective, we worked to raise awareness of stability threats. Our decision to begin publishing our Financial System Review (FSR) in 2002 showed our early commitment to promoting financial stability. We used the phrase “global imbalances” a lot in speeches leading up to the crisis. In other words, we weren’t content to just stand on the sidelines and wait to clean up messes. The widespread and extremely high cost of the Great Recession made it clear just how difficult the clean-up job can be. It has been roughly seven years since the crisis, and the damage done to the global economy has left many central banks still struggling with weak growth and inflation. However, the more fundamental lesson we learned is that “lean versus clean” is a false dichotomy. It’s far too simplistic to say that financial stability threats compel central banks to choose between leaning and cleaning. In a perfect world, we would have a macroeconomic model sophisticated enough to capture the emergence and resolution of financial imbalances, along with their related impacts on the real economy. With such a model, we would be able to incorporate financial stability threats into our reaction function, if not with absolute precision, then at least as well as we incorporate other economic variables. Unfortunately, we don’t live in that perfect world. A general-equilibrium model containing a grand synthesis of real and financial variables doesn’t exist and isn’t likely to. I don’t mean to downplay the importance of research and the development of stylized models, which are crucial in helping us understand aspects of the relationship between the real economy and financial stability. But the reality is that central banks have to cope with tremendous uncertainty regarding financial stability issues, and this is layered on top of the regular uncertainties of monetary policy concerning unobservable variables such as potential output. Given all of the uncertainty, it seems to me the proper response of the monetary authority is to acknowledge and accept all the things we don’t know, gauge the risks facing the economy as best we can, and manage those risks as we conduct monetary policy. I’ll describe our risk-management framework in detail later on. But we still have the question of how policymakers should respond to financial imbalances, particularly those that are concentrated in a specific sector or asset class. The Bank of Canada’s view is that monetary policy should be the last line of defence against threats to financial stability, behind the joint responsibility of borrowers and lenders, appropriate regulatory oversight within the financial sector, and sound macroprudential policies. Let me say a little bit about each of these. Financial stability threats – lines of defence Borrowers and lenders are the first line of defence. They bear the ultimate responsibility for their own decisions at the individual and firm level. It is not the role of monetary policy to protect individuals from making bad choices. It is possible that the sum of those bad decisions could threaten financial stability or the economy as a whole, and so we monitor the situation as a matter of course. But there is no reason to assume that, in all circumstances, equilibrium will devolve into turmoil as borrowers and lenders inevitably sow the seeds of a financial crisis. Indeed, market discipline enhanced by appropriate transparency can be very helpful in this regard. That’s not to say policy-makers have no role in enhancing this line of defence. Financial education and efforts to improve financial literacy can help consumers better understand the important decisions they make. In Canada, we have seen increasing levels of household debt that represent a key vulnerability for the financial system. The main driver behind this rise has been an increase in home-backed debt against a backdrop of rising house prices, particularly in two of Canada’s BIS central bankers’ speeches largest cities – Toronto and Vancouver. Among other factors, this was due to low interest rates that resulted in the ratio of debt service to income, including principal repayment, remaining roughly unchanged since 2008. Given this, the increase in household debt levels is no surprise. Rather, this rational response by consumers to easy monetary policy is a sign that the transmission mechanism has been working. I’m not trying to diminish the threat posed by elevated household debt. We are continuing to watch this closely. The point is that there is more to the story than the debt-to-income ratio. Because house prices have generally been rising faster than incomes, we have seen increases in the size of a first-time mortgage that a new borrower might take out. Mathematically, the total debt-to-income ratio rises as a result. But it doesn’t necessarily mean an increase in the vulnerability of the economy or the financial system. The second line of defence is sound regulatory oversight of the financial sector. This oversight has been significantly strengthened since the financial crisis. Basel III has made the world a safer place; there can be no doubt about that. But even before the crisis, Canada’s banking system was well served by its strong regulatory environment and prudent culture, which allowed our institutions to avoid the worst of the turmoil. Given the scale of the damage caused by the financial crisis, it’s not surprising that authorities devised a reform agenda of corresponding proportions. The G20 pledged to do everything necessary to address the weaknesses exposed by the crisis. With Basel III, we gave ourselves an ambitious task. We aimed for a financial reform package that would be implemented consistently across jurisdictions and would not impede the ability of financial institutions to innovate, intermediate and foster economic growth. The road to implementation hasn’t been as smooth as one would like. But that’s hardly surprising, given the political processes and trade-offs required to put the reforms in place and the many differences among the jurisdictions involved. What’s important now is that we finish the job. Ensuring the safety of the global financial system is in all of our interests. We can’t be distracted and lose sight of this objective. For financial institutions, that means meeting both the letter and the spirit of the new capital and liquidity regulations. And policy-makers should expect institutions to respond to the new regulatory regime. We are seeing competitive forces leading to innovation, in market-based finance, for example. To be clear, such innovation is a good thing. Even as we implement the new rules, we need to be cognizant of their full impact and ensure that we don’t stifle competition and innovation. That said, the scars of the financial crisis will not fade quickly, and we are determined not to let another such crisis occur. The proper implementation of the Basel rules will go a long way to preventing certain threats to financial stability from forming in the first place. It will also reduce the potential consequences of those threats by making the financial system much more resilient. Nonetheless, Basel III can’t prevent the formation of all financial imbalances, such as those in housing markets. Elevated house prices can become a concern for central bankers, particularly if they are associated with higher levels of household indebtedness and leverage. And we know that house prices can deviate in a meaningful way from underlying fundamentals, especially if expectations of price gains are based on simple extrapolations and become disconnected from economic fundamentals. A sudden reversal of such misalignments can cause significant stress in the financial system and the economy as a whole. That is where the third line of defence – macroprudential policy – comes into play. Macroprudential policies have a relatively short history, and there isn’t a lot of empirical evidence yet. But one set of tools that has been used more frequently and studied more extensively consists of those that deal with housing. The International Monetary Fund and several central banks – including the Bank of Canada – have looked at this area. They’ve found that some macroprudential policies, such as limits on mortgage loan-to-value ratios BIS central bankers’ speeches and increased capital weight on bank holdings of mortgages – can moderate the growth of credit and house prices as well as improve the average creditworthiness of borrowers. The impact of recent macroprudential tightening in Canada, which was aimed primarily at rules for insured mortgages, appears to support these findings. If we accept that properly implemented macroprudential policies can help to effectively combat financial vulnerabilities by strengthening resilience in the financial system and reducing systemic risk, this supports the view that authorities should look to these policies first when imbalances arise, before turning to monetary policy. Across the advanced economies, there is a wide variety of governance models for macroprudential policy-making. In many cases, the mandate is centralized – sometimes within the central bank, as is the case at the Bank of England, or outside the central bank, as in the United States. Some macroprudential bodies have the power to write regulations; others are limited to monitoring and making recommendations. While their precise roles may differ, it’s crucial that central banks be involved, because we bring a unique, system-wide perspective that can help identify and assess systemic vulnerabilities and risks. Further, our interests in financial stability cut across the Bank of Canada’s functions – not only do we need a well-functioning financial system to transmit our monetary policy, but we also have oversight of systemically important financial market infrastructures and, of course, we are the lender of last resort to the system. When more than one body is involved in macroprudential policy, there needs to be a mechanism to discuss and coordinate responses and to provide checks and balances within the regulatory system. In Canada, the Senior Advisory Committee fulfills this role. The committee is chaired by the Deputy Minister of Finance and includes the Bank of Canada, the Office of the Superintendent of Financial Institutions, the Canada Deposit Insurance Corporation and the Financial Consumer Agency of Canada. It is an informal forum where members can share information and perspectives on their own policies as well as on the overall regulatory environment. The committee’s strength lies in the way it allows members to understand the views of other members and to coordinate macroprudential policies, which is essential, given the potential side effects that macroprudential and monetary policies can have on each other. The last line of defence is monetary policy, and this is the context in which we think of leaning against imbalances. To be clear, I’m defining leaning as choosing a different path for interest rates than would be optimal for the inflation target in order to mitigate risks to financial stability. This could mean, for example, accepting a significant delay in getting inflation back to target so as not to exacerbate financial vulnerabilities along the way. Understanding the links At this point, let me remind you of a complicating factor for policy-makers that I mentioned earlier – the fact that macroeconomic and financial objectives aren’t always consistent. It’s clear that financial system policies – including global frameworks such as Basel III and country-specific macroprudential policies – can reduce the likelihood of financial imbalances and crises by reducing tail risks. However, it is also clear that these policies, and the state of the financial system in general, can also influence the effectiveness of monetary policy. So we need to deepen our understanding of the links and potential trade-offs between monetary and financial system policies. Let me explain. Sometimes the economic and financial cycles move in tandem. Consider a demand shock where excess demand and upward inflationary pressure lead the central bank to raise interest rates. Here, monetary policy can restrain both demand and credit growth. Now consider a different scenario, where a central bank is running easy monetary policy to try to encourage borrowing and spending. Over time, the increased borrowing could potentially lead to imbalances, in the housing market for example. In this case, you could BIS central bankers’ speeches have macroprudential policy tightening that’s working in the opposite direction of monetary policy. It’s therefore crucial to deepen our understanding of how the various transmission channels for monetary policy can be affected by variables that could be targets for financial system policies. Central banks, including the Bank of Canada, have made progress in developing new economic models and adapting existing ones to integrate financial system variables and stresses as we conduct monetary policy. We’ve added potential sources of vulnerability, such as the balance sheets of households, companies and banks, to our macroeconomic models. We are using enhanced frameworks, fuelled by more and better data, to help monitor the financial system and make more informed judgments about stability risks and how they might interact with each other. We have boosted the profile of our semi-annual FSR publication. We will continue to strive for a better understanding of the interactions between monetary policy and financial stability, and I expect to see a large amount of groundbreaking research that will shed light on various aspects of this relationship. However, there is a fundamental problem – policy-makers need models that analyze a wide variety of variables and shocks in order to do their projections, but it is enormously difficult to capture bubble-related behaviour within a typical general-equilibrium model. So we have to rely on our regular models and supplement them with stylized models that give us insights into specific financial stability issues. These models show us a view of certain parts of the economic picture, but we will never have a single tool that can provide the complete picture by itself. Risk management in monetary policy So, given that we’re working with an incomplete picture of the economy, what is a central bank to do? At the Bank of Canada we take a risk-management approach to monetary policy. Let me explain what that means, and what it doesn’t mean. Since the early 1990s, inflation targeting has become increasingly popular among central banks, and Canada was an early adopter. Under our current agreement, we aim to keep inflation around a target of 2 per cent, and we usually try to accomplish this over six to eight quarters. Even in the absence of financial stability threats, the practice of monetary policy requires the central banker to deal with vast amounts of uncertainty. Think of the most important aspects of a macroeconomic model – the level and growth rate of potential output, the real neutral interest rate, and the transmission of terms-of-trade shocks. None of these can be observed; they all must be estimated. The assumptions that we make in running our models inject uncertainty throughout the policy-making process. And, since the crisis, we have also been confronted with the risk that our models have been distorted because of fundamental shifts in economic behaviour. Now, on top of all this uncertainty, we have to add the uncertainty represented by risks to financial stability, a concept that is difficult to quantify. Adding this whole other dimension of uncertainty complicates the practice of monetary policy by forcing us to weigh both sets of risks, the probabilities that they will be realized and the potential consequences of a policy error. So how do we manage the risks? At the Bank of Canada, we try to be realistic about the things we don’t know and do a thorough examination of the related risks. Every time we come to a decision, there are a number of potential paths for policy that could be consistent with the inflation goal. In the process of formulating policy, we weigh these possibilities and focus on those that fall into a zone where the range of likely outcomes makes us reasonably certain that we’ll achieve the inflation target over an acceptable time frame and that financial stability risks will evolve in a constructive way. BIS central bankers’ speeches Still, we know there can be times when setting policy to achieve the inflation target within the usual time frame can increase the level of financial stability risk to an unacceptable level. This would take us out of the zone where the risks are essentially balanced. Because the flexibility in our framework allows it, we reserve the right to choose our policy tactics so that our actions don’t significantly worsen financial stability concerns by opting for a policy path that aims to return inflation to target over a longer time frame than normal. Risk management, then, does not mean that the central bank will adjust policy to try to lean against every emerging financial imbalance. Since we are an inflation- targeting central bank, our policy tool must always be directed first at our inflation target. Even in extreme conditions, when financial stability risks constrain monetary policy from achieving the inflation target over a reasonable time frame, a central bank would want to ensure that all macroprudential options were exhausted before trying to address those risks with monetary policy. Let me give a real-life example to illustrate how we put our risk-management approach into practice. Last year, before the oil price shock hit the Canadian economy, our policy was in the zone I just described, with inflation on course to return to target in a reasonable time frame and vulnerabilities in the household sector looking as if they would evolve constructively. The oil price shock changed the outlook dramatically. It represented a potentially sizable reduction of our national income and threatened to drive inflation below target for an unacceptably long time. The expected sharp decline in economic activity and employment also represented a possible trigger for Canadian financial stability risks related to elevated household debt. Our monetary policy was knocked out of the zone, and the downside risk to future inflation was material. So, in January, we lowered our policy interest rate, and we did so again six months later as the impact of the shock became clearer. We knew that easing policy would have implications for financial stability. However, we also knew that those concerns had to remain subordinate to the primary mission of achieving our inflation target and getting our policy back in the zone where the risks are balanced. Our riskmanagement approach implied that, in the absence of any additional macroprudential measures, our actions would affect the balance of risks in opposite directions. Lowering interest rates could worsen vulnerabilities related to household debt at the margin, but it would also lessen the chances of the oil price shock triggering financial stability risks. In the current context, getting the economy back to full capacity with inflation on target is central to promoting financial stability over the longer term. Conclusion It’s time to conclude. The dramatic events of the financial crisis required a dramatic reaction. New financial sector rules are being implemented to make the global economy safer. For financial institutions, this is a long and difficult path, but the stakes are too high to contemplate leaving the job incomplete. Policy-makers are working hard to understand the impact of new regulations and to develop effective frameworks and best practices for implementing macroprudential policies. For central banks, we know that financial stability has now become a permanent preoccupation. We can’t have a firm grasp on the economy and its outlook without also having a good understanding of the links between financial stability and monetary policy. At the Bank of Canada, we will remain committed to delivering on our mandated inflation goal. We will continue to strive toward improving our understanding of how monetary policy and financial stability influence each other. And we will continue to use the flexibility in our inflation targeting framework as needed to integrate financial stability concerns into the conduct of monetary policy, while always keeping inflation control as our primary mission. BIS central bankers’ speeches
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Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the National Association for Business Economics, Washington, DC, 12 October 2015.
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Stephen S Poloz: Integrating financial stability into monetary policy Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the National Association for Business Economics, Washington, DC, 12 October 2015. * * * I would like to thank Don Coletti and Stephen Murchison for their help in preparing this speech. Introduction I appreciate the opportunity to be part of this event. As usual, NABE is confronting some of the most important and difficult issues in economics at this meeting. For central bankers, as we work to understand and react to the aftermath of the global financial crisis, the key question is how we should integrate financial stability concerns into the conduct of monetary policy. Over the weekend, I attended the annual meetings of the International Monetary Fund and the World Bank, where this question was a topic of discussion. There is some urgency to this issue, given the way the crisis highlighted how much we have yet to learn about the linkages between the financial system and the real economy. If you think back to the pre-crisis period, nobody gave much credence to the idea that focusing on price stability could somehow contribute to the buildup of dangerous imbalances. Central bankers now know that we must consider financial stability as we set policy. The idea that central bankers should pay little heed to financial stability issues and simply “stick to our knitting” of inflation control – a position once advocated by many – seems quaintly naïve. Fortunately, the profession appears to be up to the challenge. Understanding real-financial linkages is a research priority at the Bank of Canada and elsewhere. After all, we’ve seen how financial imbalances in one sector of one economy can be amplified and propagated across the entire financial system, leading to the worst global downturn since the Great Depression. So what I will do today is share our perspective on how we integrate financial stability concerns into the pursuit of our goals of price stability and macroeconomic stabilization. This exercise is fraught with risks and uncertainties, and it is complicated by the fact that macroeconomic and financial stability objectives are not always consistent with each other. Coping with this becomes a problem, not of policy optimization, but of risk management. In other words, we put aside the idea of engineering the perfect policy and focus instead on the more realistic goal of finding an appropriate policy setting, given the risks and uncertainties. Monetary policy and financial imbalances The debate about using monetary policy to respond to financial imbalances has evolved rapidly since the pre-crisis era. A decade or so ago, the discussion was essentially between those who argued that monetary authorities should lean against imbalances such as asset-price bubbles and those who said that monetary policy should be reserved for cleaning up the mess after the bubble popped. Before the financial crisis, the Bank of Canada basically straddled the two camps. On the one hand, we argued that it’s very difficult to identify an asset-price bubble, and central bankers have no comparative advantage in making this determination. Like many, we questioned the wisdom of using the blunt instrument of interest rates on a bubble that could be confined to one asset class. Indeed, if a bubble was particularly large and persistent, a central bank that used the cure of higher interest rates could end up causing the very economic damage it was trying to prevent. On the other hand, the Bank recognized that price stability was a necessary, but not sufficient, condition for financial stability. Given our keen interest in a well-functioning financial system and our macro perspective, we worked to raise awareness of stability threats. Our decision to BIS central bankers’ speeches begin publishing our Financial System Review (FSR) in 2002 showed our early commitment to promoting financial stability. We used the phrase “global imbalances” a lot in speeches leading up to the crisis. In other words, we weren’t content to just stand on the sidelines and wait to clean up messes. The widespread and extremely high cost of the Great Recession made it clear just how difficult the clean-up job can be. It has been roughly seven years since the crisis, and the damage done to the global economy has left many central banks still struggling with weak growth and inflation. However, the more fundamental lesson we learned is that “lean versus clean” is a false dichotomy. It’s far too simplistic to say that financial stability threats compel central banks to choose between leaning and cleaning. In a perfect world, we would have a macroeconomic model sophisticated enough to capture the emergence and resolution of financial imbalances, along with their related impacts on the real economy. With such a model, we would be able to incorporate financial stability threats into our reaction function, if not with absolute precision, then at least as well as we incorporate other economic variables. Unfortunately, we don’t live in that perfect world. A general-equilibrium model containing a grand synthesis of real and financial variables doesn’t exist and isn’t likely to. I don’t mean to downplay the importance of research and the development of stylized models, which are crucial in helping us understand aspects of the relationship between the real economy and financial stability. But the reality is that central banks have to cope with tremendous uncertainty regarding financial stability issues, and this is layered on top of the regular uncertainties of monetary policy concerning unobservable variables such as potential output. Given all of the uncertainty, it seems to me the proper response of the monetary authority is to acknowledge and accept all the things we don’t know, gauge the risks facing the economy as best we can, and manage those risks as we conduct monetary policy. I’ll describe our riskmanagement framework in detail later on. But we still have the question of how policy-makers should respond to financial imbalances, particularly those that are concentrated in a specific sector or asset class. The Bank of Canada’s view is that monetary policy should be the last line of defence against threats to financial stability, behind the joint responsibility of borrowers and lenders, appropriate regulatory oversight within the financial sector, and sound macroprudential policies. Let me say a little bit about each of these. Financial stability threats – lines of defence Borrowers and lenders are the first line of defence. They bear the ultimate responsibility for their own decisions at the individual and firm level. It is not the role of monetary policy to protect individuals from making bad choices. It is possible that the sum of those bad decisions could threaten financial stability or the economy as a whole, and so we monitor the situation as a matter of course. But there is no reason to assume that, in all circumstances, equilibrium will devolve into turmoil as borrowers and lenders inevitably sow the seeds of a financial crisis. Indeed, market discipline enhanced by appropriate transparency can be very helpful in this regard. That’s not to say policy-makers have no role in enhancing this line of defence. Financial education and efforts to improve financial literacy can help consumers better understand the important decisions they make. In Canada, we have seen increasing levels of household debt that represent a key vulnerability for the financial system. The main driver behind this rise has been an increase in home-backed debt against a backdrop of rising house prices, particularly in two of Canada’s largest cities – Toronto and Vancouver. Among other factors, this was due to low interest rates that resulted in the ratio of debt service to income, including principal repayment, remaining roughly unchanged since 2008. Given this, the increase in household debt levels is no surprise. Rather, BIS central bankers’ speeches this rational response by consumers to easy monetary policy is a sign that the transmission mechanism has been working. I’m not trying to diminish the threat posed by elevated household debt. We are continuing to watch this closely. The point is that there is more to the story than the debt-to-income ratio. Because house prices have generally been rising faster than incomes, we have seen increases in the size of a first-time mortgage that a new borrower might take out. Mathematically, the total debt-to-income ratio rises as a result. But it doesn’t necessarily mean an increase in the vulnerability of the economy or the financial system. The second line of defence is sound regulatory oversight of the financial sector. This oversight has been significantly strengthened since the financial crisis. Basel III has made the world a safer place; there can be no doubt about that. But even before the crisis, Canada’s banking system was well served by its strong regulatory environment and prudent culture, which allowed our institutions to avoid the worst of the turmoil. Given the scale of the damage caused by the financial crisis, it’s not surprising that authorities devised a reform agenda of corresponding proportions. The G20 pledged to do everything necessary to address the weaknesses exposed by the crisis. The proper implementation of the Basel rules will go a long way to preventing certain threats to financial stability from forming in the first place. It will also reduce the potential consequences of those threats by making the financial system much more resilient. Nonetheless, Basel III can’t prevent the formation of all financial imbalances, such as those in housing markets. Elevated house prices can become a concern for central bankers, particularly if they are associated with higher levels of household indebtedness and leverage. And we know that house prices can deviate in a meaningful way from underlying fundamentals, especially if expectations of price gains are based on simple extrapolations and become disconnected from economic fundamentals. A sudden reversal of such misalignments can cause significant stress in the financial system and the economy as a whole. That is where the third line of defence – macroprudential policy – comes into play. Macroprudential policies have a relatively short history, and there isn’t a lot of empirical evidence yet. But one set of tools that has been used more frequently and studied more extensively consists of those that deal with housing. The International Monetary Fund and several central banks – including the Bank of Canada – have looked at this area. They’ve found that some macroprudential policies, such as limits on mortgage loan-to-value ratios and increased capital weight on bank holdings of mortgages – can moderate the growth of credit and house prices as well as improve the average creditworthiness of borrowers. The impact of recent macroprudential tightening in Canada, which was aimed primarily at rules for insured mortgages, appears to support these findings. If we accept that properly implemented macroprudential policies can help to effectively combat financial vulnerabilities by strengthening resilience in the financial system and reducing systemic risk, this supports the view that authorities should look to these policies first when imbalances arise, before turning to monetary policy. Across the advanced economies, there is a wide variety of governance models for macroprudential policy-making. In many cases, the mandate is centralized – sometimes within the central bank, as is the case at the Bank of England, or outside the central bank, as in the United States. Some macroprudential bodies have the power to write regulations; others are limited to monitoring and making recommendations. While their precise roles may differ, it’s crucial that central banks be involved, because we bring a unique, system-wide perspective that can help identify and assess systemic vulnerabilities and risks. Further, our interests in financial stability cut across the Bank of Canada’s functions – not only do we need a well-functioning financial system to transmit our monetary policy, but we also have oversight of systemically important financial market infrastructures and, of course, we are the lender of last resort to the system. BIS central bankers’ speeches When more than one body is involved in macroprudential policy, there needs to be a mechanism to discuss and coordinate responses and to provide checks and balances within the regulatory system. In Canada, the Senior Advisory Committee fulfills this role. The committee is chaired by the Deputy Minister of Finance and includes the Bank of Canada, the Office of the Superintendent of Financial Institutions, the Canada Deposit Insurance Corporation and the Financial Consumer Agency of Canada. It is an informal forum where members can share information and perspectives on their own policies as well as on the overall regulatory environment. The committee’s strength lies in the way it allows members to understand the views of other members and to coordinate macroprudential policies, which is essential, given the potential side effects that macroprudential and monetary policies can have on each other. The last line of defence is monetary policy, and this is the context in which we think of leaning against imbalances. To be clear, I’m defining leaning as choosing a different path for interest rates than would be optimal for the inflation target in order to mitigate risks to financial stability. This could mean, for example, accepting a significant delay in getting inflation back to target so as not to exacerbate financial vulnerabilities along the way. Understanding the links At this point, let me remind you of a complicating factor for policy-makers that I mentioned earlier – the fact that macroeconomic and financial objectives aren’t always consistent. It’s clear that financial system policies – including global frameworks such as Basel III and countryspecific macroprudential policies – can reduce the likelihood of financial imbalances and crises by reducing tail risks. However, it is also clear that these policies, and the state of the financial system in general, can also influence the effectiveness of monetary policy. So we need to deepen our understanding of the links and potential trade-offs between monetary and financial system policies. Let me explain. Sometimes the economic and financial cycles move in tandem. Consider a demand shock where excess demand and upward inflationary pressure lead the central bank to raise interest rates. Here, monetary policy can restrain both demand and credit growth. Now consider a different scenario, where a central bank is running easy monetary policy to try to encourage borrowing and spending. Over time, the increased borrowing could potentially lead to imbalances, in the housing market for example. In this case, you could have macroprudential policy tightening that’s working in the opposite direction of monetary policy. It’s therefore crucial to deepen our understanding of how the various transmission channels for monetary policy can be affected by variables that could be targets for financial system policies. These types of questions are urgent research priorities for the Bank of Canada as we work toward renewing our inflation- targeting agreement with the federal government next year. Indeed, assessing the costs and benefits of possible monetary policy interventions to address financial stability concerns continues to be a priority in the lead-up to the renewal. Let me give you a taste of some of the specific areas the Bank is looking at in terms of the relationship between financial stability and monetary policy. We are gathering empirical evidence about the effects of household debt levels on monetary policy. We are conducting research specifically on financial imbalances in the household sector to determine the best way to minimize the risk of future crises. We are developing models that will do a better job of quantifying the costs and benefits of using monetary policy to combat the build-up of imbalances. We are drawing lessons from the experiences of other central banks and the different ways they have reacted to financial stability developments. And we are looking at ways of measuring how much safer the financial system has become following regulatory reform in Canada and elsewhere. You can monitor the results of these efforts on our website, where we have a section dedicated to the research that is informing the renewal of the inflation-control target. BIS central bankers’ speeches Central banks, including the Bank of Canada, have made progress in developing new economic models and adapting existing ones to integrate financial system variables and stresses as we conduct monetary policy. We’ve added potential sources of vulnerability, such as the balance sheets of households, companies and banks, to our macroeconomic models. We are using enhanced frameworks, fuelled by more and better data, to help monitor the financial system and make more informed judgments about stability risks and how they might interact with each other. We have boosted the profile of our semi-annual FSR publication. We will continue to strive for a better understanding of the interactions between monetary policy and financial stability, and I expect to see a large amount of groundbreaking research that will shed light on various aspects of this relationship. However, there is a fundamental problem – policy-makers need models that analyze a wide variety of variables and shocks in order to do their projections, but it is enormously difficult to capture bubble-related behaviour within a typical general-equilibrium model. So we have to rely on our regular models and supplement them with stylized models that give us insights into specific financial stability issues. These models show us a view of certain parts of the economic picture, but we will never have a single tool that can provide the complete picture by itself. Risk management in monetary policy So, given that we’re working with an incomplete picture of the economy, what is a central bank to do? At the Bank of Canada we take a risk-management approach to monetary policy. Let me explain what that means, and what it doesn’t mean. Since the early 1990s, inflation targeting has become increasingly popular among central banks, and Canada was an early adopter. Under our current agreement, we aim to keep inflation around a target of 2 per cent, and we usually try to accomplish this over six to eight quarters. Even in the absence of financial stability threats, the practice of monetary policy requires the central banker to deal with vast amounts of uncertainty. Think of the most important aspects of a macroeconomic model – the level and growth rate of potential output, the real neutral interest rate, and the transmission of terms-of-trade shocks. None of these can be observed; they all must be estimated. The assumptions that we make in running our models inject uncertainty throughout the policy-making process. And, since the crisis, we have also been confronted with the risk that our models have been distorted because of fundamental shifts in economic behaviour. Now, on top of all this uncertainty, we have to add the uncertainty represented by risks to financial stability, a concept that is difficult to quantify. Adding this whole other dimension of uncertainty complicates the practice of monetary policy by forcing us to weigh both sets of risks, the probabilities that they will be realized and the potential consequences of a policy error. So how do we manage the risks? At the Bank of Canada, we try to be realistic about the things we don’t know and do a thorough examination of the related risks. Every time we come to a decision, there are a number of potential paths for policy that could be consistent with the inflation goal. In the process of formulating policy, we weigh these possibilities and focus on those that fall into a zone where the range of likely outcomes makes us reasonably certain that we’ll achieve the inflation target over an acceptable time frame and that financial stability risks will evolve in a constructive way. Still, we know there can be times when setting policy to achieve the inflation target within the usual time frame can increase the level of financial stability risk to an unacceptable level. This would take us out of the zone where the risks are essentially balanced. Because the flexibility in our framework allows it, we reserve the right to choose our policy tactics so that our actions don’t significantly worsen financial stability concerns by opting for a policy path that aims to return inflation to target over a longer time frame than normal. BIS central bankers’ speeches Risk management, then, does not mean that the central bank will adjust policy to try to lean against every emerging financial imbalance. Since we are an inflation- targeting central bank, our policy tool must always be directed first at our inflation target. Even in extreme conditions, when financial stability risks constrain monetary policy from achieving the inflation target over a reasonable time frame, a central bank would want to ensure that all macroprudential options were exhausted before trying to address those risks with monetary policy. Let me give a real-life example to illustrate how we put our risk-management approach into practice. Last year, before the oil price shock hit the Canadian economy, our policy was in the zone I just described, with inflation on course to return to target in a reasonable time frame and vulnerabilities in the household sector looking as if they would evolve constructively. The oil price shock changed the outlook dramatically. It represented a potentially sizable reduction of our national income and threatened to drive inflation below target for an unacceptably long time. The expected sharp decline in economic activity and employment also represented a possible trigger for Canadian financial stability risks related to elevated household debt. Our monetary policy was knocked out of the zone, and the downside risk to future inflation was material. So, in January, we lowered our policy interest rate, and we did so again six months later as the impact of the shock became clearer. We knew that easing policy would have implications for financial stability. However, we also knew that those concerns had to remain subordinate to the primary mission of achieving our inflation target and getting our policy back in the zone where the risks are balanced. Our riskmanagement approach implied that, in the absence of any additional macroprudential measures, our actions would affect the balance of risks in opposite directions. Lowering interest rates could worsen vulnerabilities related to household debt at the margin, but it would also lessen the chances of the oil price shock triggering financial stability risks. In the current context, getting the economy back to full capacity with inflation on target is central to promoting financial stability over the longer term. Conclusion It’s time to conclude. The dramatic events of the financial crisis required a dramatic reaction. New financial sector rules are being implemented to make the global economy safer. Policymakers are working hard to understand the impact of new regulations and to develop effective frameworks and best practices for implementing macroprudential policies. For central banks, we know that financial stability has now become a permanent preoccupation. We can’t have a firm grasp on the economy and its outlook without also having a good understanding of the links between financial stability and monetary policy. This is a critical area of research for central bankers everywhere, and we look forward to the contributions that economists will make in the months and years ahead.] At the Bank of Canada, we will remain committed to delivering on our mandated inflation goal. We will continue to strive toward improving our understanding of how monetary policy and financial stability influence each other. And we will continue to use the flexibility in our inflation targeting framework as needed to integrate financial stability concerns into the conduct of monetary policy, while always keeping inflation control as our primary mission. BIS central bankers’ speeches
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Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 21 October 2015.
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Stephen S Poloz: Release of the Monetary Policy Report Opening statement by Mr Stephen S Poloz, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, Ontario, 21 October 2015. * * * Good morning. We are happy to be here to answer your questions about today’s interest rate announcement, and our October Monetary Policy Report (MPR). We will begin with a few remarks about the issues that were most important to the Governing Council’s deliberations. Let’s start with the global context. We expect the global economy to strengthen over the next couple of years, although on a lower path than predicted in our last MPR in July. Growth is being supported by accommodative monetary policy and the positive effects of low oil prices in a number of economies. The U.S. economy continues to strengthen largely as we expected, shaking off the temporary factors that held it back earlier in the year. We see particular strength in areas that are important to Canadian exports, such as business investment. However, we also see weaker growth prospects in a number of emerging-market economies, particularly China. Governing Council spent a lot of time discussing what this means for Canada. There has been volatility in financial markets and downward pressure on the prices of many commodities that Canada sells. China is transitioning to a lower and more sustainable long-term growth path. While this transition may not happen in a straight line, China should continue to be a solid source of growing demand for commodities. If you look at Chart 8 of the MPR, for example, you’ll see that Chinese imports of copper are still rising strongly in volume terms. Nonetheless, there is downside risk for some emerging-market economies, particularly in the context of U.S. monetary-policy normalizing. In our discussions, we thought it was important to keep in mind that many of these countries have become more resilient in recent years: they have been restructuring their economies, strengthening their fiscal positions, and moving to more flexible exchange rates. Given these factors, if uncertainty fades about the prospects for China and other emerging markets, there is some upside risk to our commodity price assumptions, with implications for Canada. Let’s now turn to Canada. While the first half of the year was weak, there are clear signs of a pickup in growth. Taken as a whole, the second half should see growth in line with our July outlook, and we expect the economy will gather strength over the next couple of years. The complex adjustment to Canada’s terms of trade shock is playing out over two tracks. In the resource sector, we see firms cutting production and investment. We are also seeing spillovers into other areas of the economy. It’s not surprising that car sales and housing markets in energy-producing regions aren’t doing as well as those in other regions. We estimate that the oil price shock, on its own, took about 1 1/4 percentage points off GDP growth in the first half of the year. At the same time, Canada’s non-resource economy is doing much better. Table 4 in the MPR shows that retail sales, housing starts and labour markets are showing solid strength outside of the energy-intensive provinces. Non-energy exports are also showing encouraging signs. You’ll recall that in July we were puzzled because non-energy exports had faltered by more than would have been expected given developments in the United States. So Bank staff have updated the analysis that they did last year by looking at more than 4,000 export categories. This work was posted today on our web site. It shows that categories of exports that were expected to lead the recovery – such as building materials and fabricated metal products – have grown strongly in recent months, and new sources of export growth are emerging. BIS central bankers’ speeches While it’s clear that there are risks to our outlook, the bottom line is that economic momentum is building in Canada. Real GDP growth should increase over the next two years, although by less than we forecast in July. Lower commodity prices and the drop in energy-related business investment are acting as significant drags. At the same time, stronger U.S. demand, a lower Canadian dollar and the monetary stimulus we added earlier this year are all having a positive effect on growth. Governing Council considered carefully the implications of the commodity price shock on potential output because it is important to gauging the outlook for inflation. Potential output growth – the sustainable rate of non-inflationary growth – is a tricky thing to estimate under normal circumstances. It is even more so now, due to the adjustments in investment and jobs that are underway. Overall business investment has been revised sharply lower. This is because investment in the resource sector is being reduced faster than it is growing in the nonresource part of the economy. This means that, over the near term, potential output is likely to grow in the lower part of the range of estimates that the Bank presented in April. Potential output growth should eventually recover as existing capacity expands and new firms are created in the non-resource sectors. This process will unfold over a long period. Taking this on board, we can expect the economy to return to its full potential around mid2017. The underlying trend in inflation is still around 1.5 to 1.7 per cent. Core inflation is currently higher than the underlying trend, because the lower dollar is raising the prices of imports. Today, we published a paper that outlines our staff estimates of exchange rate passthrough to inflation. Total inflation, however, remains much lower than the underlying trend because of past declines in fuel prices. We expect inflation to return to 2 per cent in a sustainable way as the output gap closes. We see the risks around the profile for inflation as roughly balanced. As part of our risk management approach to monetary policy, Governing Council always considers financial stability risks. We know that accommodative policy has implications for financial vulnerabilities in the household sector. In the current context, getting the economy back to full capacity with inflation on target is central to supporting financial stability over the longer term. Taking all of these developments into consideration, the Bank judges that the current stance of monetary policy remains appropriate. Therefore, we kept the target for the overnight rate at 1/2 per cent. We would now be happy to take your questions. BIS central bankers’ speeches
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