Finance Committee on Oct. 19th, 2006

[The Chair, Conservative, Brian Pallister]

Pursuant to subsection 108(2) of the Standing Orders, we are studying the Report of the Governor of the Bank of Canada on Monetary Policy.

We are honoured today to have as our guest, committee members, the Governor of the Bank of Canada, David Dodge, and with him Paul Jenkins, senior deputy governor.

Welcome, gentlemen. Proceed. The floor is yours, sir.

[David Dodge, Governor of the Bank of Canada]

Thank you very much, Mr. Chairman.

It's a real pleasure to be back at this committee. It's been a year since we've been here, so I want to say that we do appreciate your taking the time to meet with us, and hopefully we'll be back on track, meeting twice a year, at the time we release our monetary policy reports. We think this is an important way to keep you informed and, through you, to keep the Canadian public informed of the bank's view on the economy and about the objective of monetary policy and the actions we're taking to achieve it.

When we appeared before this committee last October, we noted at that time that the global and Canadian economies were continuing to grow at a solid pace and that our economy appeared to be operating at full capacity. In our last monetary policy report, which we released this morning, we judged that the Canadian economy is currently operating just above capacity. While global economic growth is expected to be a little higher than we had previously anticipated, a weaker near-term outlook for the U.S. economy has curbed near-term prospects for Canadian exports and growth. The bank's outlook for growth in the Canadian economy has been revised down slightly from what we outlined in our July monetary policy report update.

The Bank's base-case projection now calls for average annual GDP growth of 2.8% in 2006, 2.5% in 2007, and 2.8% in 2008. Weakness in labour productivity growth has lead the Bank to lower its assumption for potential growth to 2.8% for the 2006-08 period. Together, these factors imply that the small amount of excess demand now in the economy will be eliminated by mid-2007.

Core inflation is expected to move a bit above 2% in the coming months but return to the 2% target by the middle of 2007 and remain there through to the end of 2008. Lower energy prices have led to a downward revision of the near-term projection for total CPI inflation. Total inflation (which includes the temporary impact of the GST reduction) will likely average about 1.5% through the second quarter of 2007, before returning to the 2% target and remaining there through to the end of 2008.

Mr. Chairman, as we noted at the time of our interest rate announcement on September 6, the risks around this base-case projection, which I've just gone through, are judged to be a little greater than they were at the time of our July update. The main upside risk relates to the momentum in household spending and housing prices here in Canada, while the main downside risk is that the U.S. economy could slow more sharply than expected, leading to lower Canadian exports. The bank judges that these risks to its inflation projection are roughly balanced.

Finally, I just note that on Tuesday we left our key policy rate unchanged at 4.25%. The current level is judged at this time to be consistent with achieving the inflation target over the medium term. We at the bank will continue to pay close attention to the evolution of these risks, as well as to economic and financial developments in the Canadian and global economies.

Mr. Chairman, that's a very quick overview. Paul and I now would be very happy to answer your questions.

[The Chair, Conservative, Brian Pallister]

Much appreciated, sir.

We'll begin with Mr. McCallum.

[John McCallum, Liberal, Markham—Unionville, ON]

I am very interested in the risks around your projection, not just the inflation projection but also the GDP growth. With the troubles in the U.S. housing market, my sense is that if a housing bubble bursts it would be more serious than a stock market bubble bursting, because of the greater portion of most people's wealth in housing. That's just my view. But how do you see the risks up and down vis-à-vis your GDP forecasts?

[David Dodge]

Let's start with the world at large. If you look around the globe, growth is probably going to be a little better than we had thought at the time of our July update, and certainly a little better than we thought last spring. That's largely due to a continued strong performance in Asia. There has been a clear recovery in Japan and Europe. In both of those areas, domestic demand is growing and looks like it's set to continue to grow a little more strongly. So that's the upside in the world. Of course, it puts continued upward pressure on global prices, particularly for resources.

On the other side, clearly the U.S. economy has slowed a little faster than we were expecting. This is largely owing to two things: housing and automobiles. If we look at the structure of our exports, housing and automobiles are very important. Housing is important not just because of lumber but also because of the windows, doors, and other things made primarily in Ontario and Quebec, together with furniture, which we see through the whole manufacturing area of the country. Automobiles are particularly important for southern Ontario.

So that's the main reason that we've downgraded our outlook for Canada over the next four quarters or so. Two questions: have we downgraded the outlook for the U.S. enough, and have we downgraded the outlook for Canada enough in respect of these factors? Actually, we don't know. The risks in our U.S. outlook are on the downside. I'm not sure, though, whether this is because of huge further deteriorations in the housing market, or whether it's because of the possibility that the significant deterioration that has already occurred could spread through other parts of household demand.

We've flagged that risk. We think that risk is clearly on one side: there's not much risk that our U.S. forecast, at least in the short term, is going to turn out to be too high. But global demand is quite strong and offsets some of that.

Now there's the other side—the upside risks. The upside risks are important and we've flagged a couple of them.

First, domestic demand, both by business and households, could well be a little stronger. We haven't upgraded our forecast, but the amount of income out there is a bit higher than we had anticipated. Second, there is a risk that the strength we've seen as being confined largely to Alberta and B.C., with a bit in Saskatchewan or Manitoba, could well spill back to a greater extent than it has so far.

So we think there's an upside risk there. There is also a risk that wages and prices, which have moved up very sharply in Alberta, could spill back. That's why we think the risks are roughly balanced, but we'll watch it over time and see.

[John McCallum, Liberal, Markham—Unionville, ON]

Thank you.

Now if I could turn briefly to fiscal policy, the economic prudence component of the safeguard against return to deficit has been removed by this government. So I suppose by definition that means fiscal policy is less prudent if the prudence is no longer there. Would you agree with that statement?

As a corollary, if there is greater risk—as I think you said in your forecasts—then maybe there's a greater need than in the past for prudence, because we have had a long string of surprising surpluses on the positive side. If the risks are greater, those days may be over, and there may be a stronger need for prudence than in the past.

It is a double question. Do you agree it's less prudent, and is there a greater need for prudence than in the past?

[David Dodge]

Let me go to the underlying factor here. What's happened, of course, is that we were surprised with the strength and growth of nominal GDP, in particular in 2004 and 2005, largely because of improvements in terms of trade.

As everyone around the table knows, we tax nominals, not reals. So revenue strength, whether it's tax revenue or royalty revenues, in Alberta in particular, has been stronger than we would have anticipated.

Now, it is absolutely true that looking forward we expect this to turn around. The bit better than 6% growth in nominal GDP, which we saw last year, we think will be below 5% this year and could well be 4% next year. So there are clear risks in terms of nominal GDP growing much more slowly than growth in real.

I think this is an issue. There are risks both on the federal level and in the provinces, which rely fairly heavily on corporate income taxes or directly on royalty revenues.

[John McCallum, Liberal, Markham—Unionville, ON]

Does the removal of the prudence component mean that by definition fiscal policy is now less prudent?

[David Dodge]

What we have assumed is that governments as a whole will adjust their spending and taxes in order to stay in fiscal balance over the period.

[John McCallum, Liberal, Markham—Unionville, ON]

I see. It wasn't a direct answer, but I'll move on.

[Some hon. members]

Oh, oh!

[John McCallum, Liberal, Markham—Unionville, ON]

I know in the Department of Finance they have various economic models showing that the effects on productivity or wealth are significantly greater for an income tax cut than for a GST cut. I know that OECD and IMF economists all converge on that point.

Do you agree that from a competiveness or productivity point of view, income tax cuts are more efficient than reductions in consumption tax?

[David Dodge]

This is always tricky, because at the bank we really don't work on that, and I have to be here to speak about the work we do.

What we focus on is the importance of fiscal balance, and in particular we focus on this at a time when we have stronger than anticipated growth. Clearly, then, we would look for governments to be running surpluses.

That's what's critical for us. Over the longer term, tax structure is critical to the economy's potential growth rate, but we are not experts in this.

[John McCallum, Liberal, Markham—Unionville, ON]

Thank you.

[Le président, Conservative, Brian Pallister]

Let us now continue with Mr. St-Cyr.

[Thierry St-Cyr, Bloc, Jeanne-Le Ber, QC]

Thank you very much, Mr. Chairman.

Thank you for your presentation. This is an entirely new concept for committee members. Now we will have ten minutes to exchange, which will allow us, I hope, to go a bit more deeply into the issues on the agenda.

For a long time, it has been taken for granted that the Bank of Canada has a policy whereby it maintains a target inflation rate between 1 and 3%. Is this a theoretical figure, or is it based on empirical data? How was this decision made at the time? How is it implemented today? Should it be revised? Is this still the best target range for Canada?

[David Dodge]

This is a good question.

Let me answer you first and then I will give the floor to Paul.

In 1991, the government and the Bank of Canada tried to find a formula for slowing down inflation, which was very high at the time. Thus, deflation targets were established until 1995. This is how the inflation rate went from 4 to 2% at the end of that period.

In 1995, we agreed to keep the target at 2%; we have renewed it twice since then. A range of 1% either way was provided, because of normal variations in inflation.

Canada was the second country to adopt this kind of system. It was a pioneer in the field. The 2% rate was not based on past experience, because the system was new, but after a few years, other countries followed our example and adopted targets. The European bank, for example, adopted a target rate of 2% or less. England also adopted a 2% rate. In other countries, the rate is 2.5 or 3%. Japan and the United States are also considering adopting such a system.

Paul might have something to add.

[Paul Jenkins, Senior Deputy Governor, Bank of Canada]

We have set a target of 2% with a range of 1% either way, but we are aiming for a total CPI growth of 2%. A large contributing factor to the efficiency of monetary policy is the expectancy regarding inflation. By setting a specific target, inflation is expected to be about 2%. This is a very important factor.

As the governor mentioned, we studied a 2% target. There are some factors, but currently, we are very satisfied with this rate.

[Thierry St-Cyr, Bloc, Jeanne-Le Ber, QC]

If I understand correctly the current 2% rate is rather arbitrary. This target was set at a given point in time. It seems to be working quite well. The others then followed.

What is the mathematical origin of this figure? This is more or less what I am trying to understand. Why should the target not be set at 2.5, 3 or 1.75%?

[David Dodge]

This was not mathematically set, but a target was chosen that would give the best economic performance. After 10 years, namely after we established a 2% target, expectations have stayed steady at 2%. It still remains to be known whether there is a target that could be even better for economic performance.

Given our own experience and that of other countries, we will study this question. This is more of an empirical question than a mathematical one.

[Thierry St-Cyr, Bloc, Jeanne-Le Ber, QC]

All right.

Let me put some questions regarding the components of inflation. I would like to know the impact of the recent cut in GST on inflation, and the impact of a further potential cut. On the other hand, what are the causes of inflation? In what areas could we anticipate serious causes of inflation in Canada over the coming years?

[David Dodge]

Let me begin to answer and then I will give the floor to Paul.

The impact of the recent cut in GST on inflation — this time we are dealing with mathematics — is a little over 0.5%, which is between 2.5% and 2.6%, and will last from July 2006 until July 2007. After July 2007, we think that the effect will disappear. But there are other factors that are much more difficult...

Paul.

[Paul Jenkins]

There is a conceptual difference between the factors affecting inflation in the medium term, such as the balance between supply and demand, and factors such as a cut in the GST, which have a temporary impact on prices.

As the governor mentioned, we see a current effect of 0.5% on the CPI, but within a year, this impact on the growth rate should no longer be visible.

[Thierry St-Cyr, Bloc, Jeanne-Le Ber, QC]

All right. How can you reconcile the demands for job growth and the fight against inflation if, for instance, the job situation were to deteriorate? Could we temporarily go beyond the target inflation's range, and throw away some ballast in order to stimulate employment and growth? How do you manage these three concepts? How do you reconcile them?

[David Dodge]

In the medium term, the best contribution that monetary policy can bring to economic performance is to maintain a low and stable inflation rate and to have very clear expectations in this respect. In the medium and long term, this is the best thing to do.

Of course, the short term inflation rate is very much influenced by pressures on the economy, either upward or downward. When there are upward pressures, when the economy is working at a level higher than its potential, there is inflationist pressure. This is when monetary policy must be tightened up.

On the other hand, when there is a great deal of slack in the economy and pressures to bring inflation down then we must exercise more expansionist pressures on monetary policy, but...