Finance Committee on May 1st, 2007

[The Chair, Conservative, Brian Pallister]

Pursuant to Standing Order 108(2), we are considering the report of the Governor of the Bank of Canada on monetary policy.

We are pleased this morning to again welcome to our committee Mr. David Dodge, the Governor of the Bank of Canada. Sir, we're pleased to have you.

We're also, I'm sure, of mixed emotions in learning of your intention not to continue in your role, and we hope it was nothing we said or did that contributed to your decision.

We welcome you. Please proceed with any introductory remarks you deem appropriate.

[David Dodge, Governor, Bank of Canada]

Thank you very much, Mr. Chairman. It's always a great pleasure for Paul and me to meet with members of this committee.

We really do appreciate the opportunity to meet with you a couple of times a year, following the release of our Monetary Policy Report. Certainly we think these meetings provide us an opportunity to keep you informed and, through you, to keep the Canadian public informed about what we are doing at the bank, about our objectives for monetary policy and how we're accomplishing them.

When Paul and I appeared before the finance committee last October, we noted then that the Bank of Canada's projections fore growth in the Canadian economy had been revised downward slightly from earlier expectations. In our latest Monetary Policy Report, which we released last Thursday, we noted that Canada's economic growth did indeed slow, but recently, inflation has been higher than expected. After considering the full range of indicators, the Bank of Canada now feels that the Canadian economy was operating just above its production capacity in the first quarter of this year.

We expect that, over the projection period, domestic demand will continue to be the main engine of growth in Canada. With the US slowdown now expected to be somewhat more prolonged than previously forecast, net exports should exert a slightly greater drag on Canada's growth in 2007. The Canadian economy is now projected to grow by 2.2% in 2007 and 2.7% in both 2008 and 2009. This will return the economy into its production capacity in the second half of 2007 and keep it there through 2008 and 2009.

Core inflation under this scenario should remain slightly above 2% over the coming months, given pressures on capacity and the impact of higher core food prices, but with the economy projected to return to its production capacity in the second half of this year, and with further easing of pressures from housing prices, upward pressure on core inflation is expected to moderate, bringing core inflation back to 2% by the end of 2007.

Total CPI inflation is projected to rise above our 2% target in the second half of this year, peaking below 3% near the end of this year, before returning to target by mid-2008.

Mr. Chairman, we at the bank continue to judge that the risks to our inflation projection are roughly balanced, although there's now a slight tilt to the upside. Last Tuesday we left the key policy rate unchanged at 4.25%, and this level is judged at this time to be consistent with achieving our inflation target over the medium term.

Mr. Chairman, and members of the committee, Paul and I will now be very happy to answer your questions.

[The Chair, Conservative, Brian Pallister]

Thank you, sir.

We'll begin with Mr. McCallum.

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

Thank you, Mr. Chair.

First of all, I'd like to congratulate the governor for his great service to the country and for hitting the inflation target right on, I think, in his period in office, and for bringing a certain humanity to the Bank of Canada. I won't go on further in this laudatory way, because I do have a couple of questions I would like to cover.

First of all, you were saying that, if anything, the inflation risk was a little bit on the upside. As you may have noticed, Andrew Coyne, in particular, has been saying that this is the biggest spending budget—a $25 billion increase in spending over two years—and that the percentage increase in government spending has been greater than the average under the past few years of the Liberal government.

So I guess my question is, in view of the fact that we have near record low unemployment and you're saying that the inflation upside risk is a little bigger than the downside risk, do you have concerns that the budget, with its large increase in spending, might be contributing to an overheating of the economy at this time?

[David Dodge]

That's a very good question.

What we do is project on the basis of government balance. Our assumption, as we've prepared our report, is that governments at all levels will basically bring in balanced budgets and operate in balance over the course of the projection period, which runs to 2009.

Now, that is an assumption, but it seems to be largely consistent with what has happened both federally and provincially, provided our projections, in terms of nominal GDP growth, actually turn out to be right. As all members of the committee know, government revenues are largely contingent on nominal GDP growth, and that has been running, up until recently, considerably higher than real because we've had favourable terms of trade.

Our projection, actually, has those favourable terms of trade flattening out and coming down, which ought to mean that the very good revenue performance that we've seen both federally and provincially ought to flatten out a little bit.

Now, that's purely a projection. So far we, in Canada, as a number of other countries, have been a bit surprised at how fast personal income tax revenues have grown relative to the growth of personal income. We don't fully understand why. In part, it may have to do with income distribution. We're not absolutely sure. But probably, at least for 2007, if there were a risk on the government balance side, the risk is that government balances will be a little more favourable than our assumption of being in balance.

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

Thank you.

On the question of interest deductibility, it seems to me that the acid test for Canada is not what is necessarily the best policy in some academic sense, but that what other countries do is critical. On the question of interest deductibility, as you know, denying our companies that, given that in foreign acquisitions most European countries and the United States and Japan are allowed to do it, puts us at a very significant disadvantage, in terms of Canadian-based companies.

As Bruce Flexman of KPMG put it, this would lead to more “foreign takeovers of Canadian companies, stifling of Canadian investment in global markets, an exodus of head offices and...a weaker long-term Canadian economy over all”.

I guess my perspective would be that one shouldn't throw the baby out with the bathwater, that it's very important for our homegrown companies to be on a level playing field with foreign companies and not to have it tilted in favour of the foreign companies. But at the same time, there may well be abuses or things to fix, in terms of this rule, technical things like capitalization rules, income being attributed to passive versus active business income, all of these things, which could be fixed.

So my question is, would you agree that rather than what might be described as a nuclear bomb approach on this issue, it might have been better—and it still is not too late—to have a more surgical approach, wherein we don't penalize our leading companies, but, at the same time, to the extent there are abuses or problems in the application of this law, we clean those up?

[David Dodge]

As you know, I've been before this committee several times over the last two and a half decades on this issue--in the mid-eighties when we tried to deal with this problem and again in the mid-nineties when we looked at it.

First of all, I think all members recognize that this is a very technically difficult area of the Income Tax Act, and trying to deal with abuses without throwing the baby out with the bathwater is just very difficult. We should deal with the abuses, but we have to be careful as we go.

I know that the department and the minister recognize this, and great effort will be taken to try to deal with it in drafting the legislation. The abuses are not something one can condone. On the other hand, as long as we don't deal with the issue of offshore tax havens globally--and they have to be dealt with globally, we can't deal with them individually in Canada--there will be a real problem in drafting the act. I'm sure the minister is aware of that.

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

Thank you.

[The Chair, Conservative, Brian Pallister]

Thank you very much.

Mr. Crête, you have seven minutes.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

Thank you, Mr. Chair.

Good day, Mr. Dodge, good day Mr. Jenkins. Mr. Dodge, I wish you every success for the remainder of your term. I hope it is smooth sailing.

The rising dollar is a matter of concern at this time. Economist Clément Gignac sums things up by saying that we are no longer wondering if parity with the US dollar will be achieved one day, but rather when that is going to happen. Could you tell us your thoughts on the possibility of parity between the two currencies? Obviously factors other than the value of the dollar are at play here, but will the dollar continue to appreciate as it has been doing for some time now?

[David Dodge]

As you're aware, there's a lot of volatility when it comes to exchange rates. We've estimated that in the first quarter of this year adjustments in the rate of exchange were more or less in keeping with the movement in commodity prices and the strength of the Canadian economy. Over the last two or three weeks, we have seen some volatility, and it is hard to comment on this. We'll have to wait and see what happens over a longer period of time. What we can say is that during the first quarter, the movement observed was more or less in line with changes in our economy and world prices.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

You know as well as I do that this has a major impact on manufacturing activities in Quebec and Ontario. Do you think that the tools we have are enough? People have told us that the main reason they've been forced over the past two or three years to make very costly and incomplete adjustments is the rapid rise of the Canadian dollar. We're not only talking about jobs being transferred elsewhere, there are people being affected in their daily lives. Will the current trend you've referred to require a much bigger response and can we continue to expect substantial job losses in the manufacturing sector in the months and years ahead?

[David Dodge]

I'll take a stab at that and then let my colleague respond. As we stated the last couple of times we appeared before this committee, we expect the percentage of jobs in the manufacturing sector to drop during this period of extremely high commodity prices coupled with a strong services sector. So, this is no surprise. Now, it is not easy to adjust, especially in the most remote communities, but this is part of an important progression towards optimal value-added in Canada. There are many factors at play, and the dollar is one of them. Asian competition is another extremely important factor. So, there are a lot of factors, but not the...

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

If I can just make one comment. It is true that China is keeping the value of its currency pegged at an unrealistic level. This heightens the affects of Asian competition which benefits from political decisions that may or may not be justified, but that nevertheless also have an impact.

[David Dodge]

And that's why we have worked very hard with the IMF, the International Monetary Fund, and other organizations in order to convince the Chinese authorities that it is in their best interests to have a far most flexible exchange rate than what they currently have.

Paul, you have the figures.

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

Yes I do and I'd like to make a few other comments. The exchange rate is an indigenous variable insofar as there are several factors which determine the dollar's movement. A rising dollar reflects, for example, the strength of the world economy, and the progression towards higher-priced commodities. It's impossible for an economy like Canada's to avoid these global factors. Our economy's flexibility, and its resilience to structural changes resulting from global forces play in Canada's favour.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

At what point would a common currency be more economically advantageous than two separate currencies? When the Canadian dollar is worth 85 US cents, there is still enough of a difference in the rate. However, as we head towards parity, the cost associated with having two currencies would be higher than for a single common currency. Have you already looked at this? When would it become more advantageous? Where would the exchange rate have to sit?

[David Dodge]

That is an excellent question, and I'll take a stab at it. There's no exact figure. It will depend on the relative change in the prices of all commodities versus the prices of the manufacturing products. It will also depend on cost adjustments in Canada and on how these costs compare to costs worldwide. To date, cost adjustments in Canada have been less marked than the increase in the nominal exchange rate. Therefore, especially in relation to the US, our real exchange rate hasn't changed. Thus far, the situation in relation to China has been completely different and may change even more down the road, especially since productions costs in China and, generally speaking, across Asia are on the rise. Also, the price of consumer goods that Canada and other countries import is not increasing, but in fact decreasing. So, we may currently be observing a slight change which we are duly taking note of and which may affect our inflation projections.

[The Chair, Conservative, Brian Pallister]

We continue now with Mr. Del Mastro for seven minutes.

[Dean Del Mastro, Conservative, Peterborough, ON]

Thank you, Mr. Chair. It's always a pleasure to have Governor Dodge and Deputy Governor Jenkins before the committee.

You've brought forward very interesting information.

I just want you to comment. One of the things that was very interesting was that you predicted that domestic demand will be the key driver of economic growth in Canada, whereas in the past we've seen exports actually being the key driver of economic growth in Canada. There were a couple of things that occurred to me on this. The government has brought in a couple of tax measures that I think may well be contributing to the economic growth. One is the reduction in GST, which also helped to mitigate inflation. We've also brought in an accelerated capital cost allowance adjustment for corporations, which should increase domestic demand on fixed assets. I just wondered if you might comment on that a little bit.

[David Dodge]

It's hard to comment on all those specifics. Let me just go back one step. During the period of the 1990s and the very first years of this decade, it was exports that were the key driver. We had rather weak domestic demand as federally and provincially we were getting our fiscal situation in shape and we really were relying heavily on foreign demand through that period to drive growth. That was also following the 1997 Asian crisis, when the price of raw materials plummeted, so the relative prices of manufacturers went up.

So we went through a period when it was the external sector that was the key driver. We now move to a period when we've had a big correction in commodity prices, and that is driving up incomes here in this country, so we are seeing the domestic sector be the key driver.

We expect that will continue, but as we get to the end of our projection period, we come much more into balance. You'll notice that by 2008 we expect net exports to be a kind of “net wash”, to not be a negative influence on growth, and maybe as we get out a little farther, this situation will actually turn around again.

Through all of these changes, the thing we've always emphasized is the importance of maintaining flexibility in the Canadian economy. In that regard, our performance in this decade, compared with our performance in the 1970s, when we had to adjust to massive changes in relative prices, has been extraordinarily good. Indeed, we've moved from being a bad performer globally in that regard to being an excellent performer globally.

What's really important in terms of policies both at the federal and provincial levels is that we maintain the drive to keep that flexibility, which allows us to adjust, because as a very open economy we're always going to be subject to pretty large swings and shocks. This time, the last decade looks pretty good relative to our historic performance in that regard.

[Dean Del Mastro, Conservative, Peterborough, ON]

Thank you.

You mentioned “swings and shocks”, but having said that, it looks as though the bank is projecting a fairly long period of stability over the next three years. Reading from the report you brought forward, it doesn't seem to me that we anticipate a lot of changes in interest rates and so forth or in inflation over the next few years.

In the U.S., the story is a little bit different. Their growth isn't quite so good. Is there a potential that the Fed in the U.S. could actually reduce interest rates, which would have the probable effect of increasing the value of the Canadian dollar against the U.S. dollar? Could we see a further rise in the Canadian dollar?

[David Dodge]

While the Fed doesn't have explicit targets such as we have, the basic objective of every central bank is to keep the economy operating reasonably close to potential and to hold inflation at very low levels. That's essentially the game we're in.

Going back to your previous question, that becomes much easier to do, from the standpoint of monetary policy, if the economy is very flexible and adjustments can take place. While we've had a lot of success, as Mr. McCallum pointed out, over the last decade, a lot of that success is not due to absolute brilliance on the part of the Bank of Canada but is due to the fact that a lot of Canadians worked very hard to make this economy more flexible over that period. This doesn't mean life is easy, but there's been a lot of hard work going on, and that is really the key to success.

[Dean Del Mastro, Conservative, Peterborough, ON]

If I could, I'll add a supplementary.

I noticed that there was a survey by Canadian Manufacturers and Exporters. A lot of them are anticipating a better year in 2007 than they had in 2006, with higher demand and potentially more employment. It would seem to me that maybe that could be pointing, even though the dollar is higher, towards their actually improving their productivity. Or is it just a little bit of optimism on their part?

[David Dodge]

The productivity measure remains to us a bit of a puzzle, as we say in our report. We don't fully understand why it is that productivity has been so weak over the last couple of years. It may be that there was actually more output there. When we get all the revisions and statistics, we may find that there's more output there. It may be, with these big intersectoral shifts going on, that we have been going through a period of time when productivity is depressed as people have to make these shifts from one sector to another.

Finally, of course, within the primary sector, particularly in oil, gas, and mining, when prices are high, the optimal way to use the resource is to actually low grade, and that means that the unit cost of production actually goes up when prices are high.

So there are a number of factors. But I would stick with it. It's still a bit of a puzzle to us.