Finance Committee on Nov. 15th, 2011

[Prof. Christopher Ragan]

Thank you. That's an excellent question, and a perennial one in Canada.

We have many sectors. We have many regions. The sectors often line up with the regions, so very often the issue arises as to whether it's desirable to have a flexible exchange rate, for example, which is an important part of Canada's monetary policy system.

This relates to the last comment that Scott made. The problem—and perhaps I can steal a phrase and say that it's just an inconvenient truth—is that we have different sectors of the economy, different regions of the economy, and they are subject to very different shocks. The best examples would be if you want to think about the west or maybe now the west and the east being exposed to world commodity prices, energy prices in particular, and producers and exporters of energy, whereas central Canada is largely a user of energy. Well, when world energy prices rise, that is going to tend to be very good for those energy-producing regions and sectors, and it's going to be bad for those sectors and regions in the economy that are net users.

That's just a fact of life. But then the question is what kind of monetary policy do you want? The current system has an inflation targeting system where we allow the exchange rate to rise and fall in response to those shocks, and we certainly have seen those adjustments in the past. Unless you're going to have multiple currency areas across Canada, and I don't think anybody is seriously suggesting that, politically or economically, then you have to deal with the fact that we are a single-currency union.

I didn't think this discussion was going to get to Europe, but it could get there very quickly.

We accept the fact that we are a single-currency union with regions with very different shocks and we deal with it. We do deal with it. That doesn't mean that there is not pain and adjustment that happens in response to these shocks, but it's one thing to recognize those shocks and it's quite another to believe that monetary policy can do something about it.

As long as we are going to have a single-currency area called Canada, the Bank of Canada needs to have a single monetary policy for Canada as a whole. So it tends to look at, and tends to be driven by, national averages as opposed to regional developments. I believe that's appropriate.

[Randy Hoback, Conservative, Prince Albert, SK]

When we look at the way Canada has performed in the last x number of years, the last three or four years, and we look at the model we've been using and basing our decisions on going through the 2008 crisis and moving forward, has anything structurally changed that would make you say we should change it?

Maybe I'll go to Mr. Alexander, and Mr. Ragan after that.

[Craig Alexander]

I think the Bank of Canada has managed monetary policy remarkably well through the financial crisis of 2008 and the economic recovery. They aggressively eased monetary policy as the financial shock hit. They took interest rates down to unheard-of levels that no economist five years in advance would ever had anticipated you would have rates decline to. It did some very out-of-the-box thinking about how to respond to the environment.

The introduction of the conditional commitment was a good example of something that hadn't been tried before and that actually, I think, showed its benefits. I think it's one of the reasons why the federal reserve has chosen to follow the same path in terms of trying to anchor interest rate expectations, at a level even lower than they otherwise would have, to provide support to the economy.

I think the decision to take interest rates off the zero per cent floor was sound. I'll be honest; I actually think zero per cent interest rates might even be creating some of the problems in the United States, because your financial system doesn't actually operate properly when there is zero per cent interest. When you have an interest-bearing chequing account, you actually have to have some interest on it or else it stops being an interest-bearing account. It's probably contributing to the problem with the circulation of money.

You know, you can always look with perfect hindsight and raise questions, but with the information they had at the time, I think they've done a remarkably good job.

[The Chair, Conservative, James Rajotte]

We're over time, Mr. Ragan, but you can add something just briefly.

[Prof. Christopher Ragan]

I have two quick comments to add to Craig's.

Number one, I think the last few years show the value of the flexibility of an inflation-targeting system. With the inflation expectations very well anchored, it liberated, if you like, the Bank of Canada to be very aggressive in its policy response. It was very aggressive, and it could be very aggressive in terms of cutting rates and doing other creative things secure in the knowledge that expectations wouldn't be dislodged.

The second thing is that in the last three or four years, I wouldn't call it a structural change, but financial stability, of course, has become an issue that central banks are thinking more about now than they were eight years ago. That's entirely appropriate and consistent with the inflation-targeting system. The flexibility, or the constrained discretion, allows the bank to think about that.

[The Chair, Conservative, James Rajotte]

Colleagues, I want to try to get everyone in. If we can shorten our questions up a bit, I would appreciate that.

Monsieur Mai.

[Hoang Mai, NDP, Brossard—La Prairie, QC]

Thank you, Mr. Chair.

To Mr. Seccareccia, you spoke about the full employment target. I think I understand the arguments regarding having one single inflation targeting, that it brings more confidence, more stability.

Can you explain to us what would be your model, or what would be your specific targeting, that would be specific enough for people to really focus on in terms of trying to understand where the Bank of Canada is heading?

[Prof. Mario Seccareccia]

It's not that the Bank of Canada doesn't have an implicit target of unemployment, it does implicitly, because it believes in some notion that there's a kind of NAIRU out there, a non-accelerating inflationary rate of unemployment. So what it wants to do is keep that economy within a certain band, which has prevented unemployment in Canada from going below 6%, basically, if you look at the last 20 years. In that regard, there's an implicit one there.

What I'm saying is that we should be able to have it explicitly, and it should be something lower than that NAIRU--that's my concern. And we should allow that band for the inflation targeting to be wider, to allow for the possibility of getting that unemployment rate lower, if indeed we do have a NAIRU there.

My belief is that if you look at the actual work and research done—I'm sure some would support me on this—there's no NAIRU here that is a constant. It varies with the unemployment rate. That's why it becomes a bigger problem. You have a central bank that believes there's something out there that exists that will prevent inflation from actually going up, which is an unemployment rate of around 6% or 7%. But, then, there are those who are saying that this NAIRU is not some constant. Hence, if you look at that work, it would suggest they have a problem even with the implicit one, as I said, that they do not officially talk about but that is there.

Now, with regard to what should be an unemployment target, I'm old enough to remember back in 1965, when they set up the old Economic Council of Canada. They came out with some very precise figures as to what should be the full employment in Canada. Indeed, in 1966 we had reached an unemployment rate in Canada of around 3.5% or less, if I remember correctly. We know that we've had unemployment rates that are far lower than the 6%, 7%, or 8% range that we've been living with over the last 20 years. My point is simply that what should be on the radar screen of the central bank should be a concern about whether that unemployment rate should be a lot lower here than what they think it should be because of the inflationary pressures argument along the lines of the NAIRU.

What should it be exactly? As I said, I could go back to the old Economic Council one of 3.5%, but it surely should be less than that 6%.

[Hoang Mai, NDP, Brossard—La Prairie, QC]

Mr. Stanford, could we hear your view on that too?

[Dr. James Stanford]

I think Mario's response has brought out a key problem in the way that the Bank of Canada looks at unemployment today. They certainly are aware of unemployment. They care about unemployment, and the level of unemployment influences their actions, as I think all of us have agreed. But in an inflation-targeting system it influences their actions in a very particular and peculiar way.

The bank has a judgment on what it views as the potential output of our economy. It doesn't actually have an explicit NAIRU estimate, but there is a NAIRU estimate embedded in its judgment of what the potential output is. The bank also has a theory that the dominant cause of inflation will be any time actual output exceeds what it judges to be the potential output, that is, the form of demand-driven or labour-market-driven inflation that the bank is most concerned with. They also understand that monetary policy acts four to eight quarters down the road. This is how the bank operationalizes its inflation target. It has a judgment of potential output down the road and then it tries to steer demand to a level that's not in excess of that level of potential output, to prevent the inflation that it expects would arise if you exceeded that output.

The problem is that this can easily become a self-fulfilling prophecy because labour markets, expectations, real capital capacity in our economy will adjust if everyone understands what the bank is doing. Then their assumed level of the NAIRU actually becomes the actual level of the NAIRU for the simple reason that we don't have the capacity or the ability to move beyond that.

If the bank were explicitly governed by at least a twin mandate of reasonable inflation and job growth, then it could test the waters a bit more to try to see where exactly inflation would pick up, because they would be trying to capture the benefits of the upside on the employment.

[The Chair, Conservative, James Rajotte]

Thank you, Mr. Mai.

We'll go to Mr. Adler, please.

[Mark Adler, Conservative, York Centre, ON]

Thank you, Chair.

Thank you, witnesses, for appearing here this morning.

I want to begin my questioning with Mr. Alexander. You mentioned before that the Bank of Canada, through its low-interest-rate policy, has provided great stimulus to the economy. Could you talk more about that?

[Craig Alexander]

When we think about how monetary policy responded to the financial shock of 2008, we need to understand that there was actually nothing structurally wrong with the Canadian economy before the financial crisis hit. What effectively happened to Canada was that we were hit with a massive external shock.

The simple reality is that fiscal policy and monetary policy in Canada cannot change external economic conditions. Canada is a small open economy. More than a third of our economy is exports. We're heavily influenced by what happens outside our borders.

When the economy went into a very steep decline and a very severe recession, there was aggressive easing of monetary policy, taking interest rates down, with the overnight rate eventually reaching zero percent.

You could actually see the positive impact that had in terms of boosting domestic demand. The best evidence of that is the fact that, starting I think in March of 2009, we had the most unique situation. We had rapidly rising unemployment accompanied by rapidly rising home sales. We have never had that correlation in the past. It was one of the reasons forecasters like me got all of their housing market forecasts wrong.

This was complemented by the renovation tax credit to help boost the inclination of consumers to spend. Ultimately, what was fiscal and monetary policy trying to do? When private sector demand was contracting, they were trying to push the other way, to encourage Canadians to do things they otherwise wouldn't have done in those economic conditions. We can actually materially see that it had a positive impact in terms of boosting the economy and limiting how deep the recession became.

Now, it does create challenges, because I do think that household debt has become very high, but I think one of the lessons we have learned from recent experience is that we need to understand that monetary policy has to be accompanied by sound fiscal policy and sound regulatory policy. One of the core differences between Canadian and U.S. experience has been that the Canadian financial system has been better regulated, has taken less risk, and was less leveraged. So while we do have challenges around the fact that rates being low for so long has boosted consumer spending and household debt, which is an issue we're going to have to address when interest rates eventually rise, I would argue that the conduct of monetary policy was extremely sound.

[Mark Adler, Conservative, York Centre, ON]

And was it the same for fiscal policy?

[Craig Alexander]

As I said, I believe that fiscal and monetary policy both contributed to limiting how deep the recession became.

[Mark Adler, Conservative, York Centre, ON]

Okay.

Also, you mentioned that the Bank of Canada pursued some “out of the box” thinking. Could you expand on that a little bit too?

[Craig Alexander]

As I said, I think the best example of that was the decision to make a conditional commitment to keep interest rates low for an extended period of time with an actual specific date associated with it. We'd never had that happen before, and it did have a material impact on the thinking in financial markets.

One of the core challenges is that investment banking, brokerage, traders will respond to day-to-day changes in economic numbers, and those will change their thinking. If you start to get some good economic numbers, but you're just coming off a very bad decline, markets will start to think about the Bank of Canada moving off the sidelines and raising rates. They would have started to price in tightening earlier than the Bank of Canada actually delivered in practice, because as the economy was recovering, markets would have gotten excited about the possibility of rates rising sooner.

The conditional commitment helped to anchor short-term rates, and then by definition the anchored low short-term rates pulled down the yield curve for longer-dated maturity. For example, a conditional commitment, in my opinion, also limited the rise in five-year mortgage rates. So it provided stimulus across the entire borrowing segment.

There is a challenge here that business confidence.... There are limits to what policy can do, and Canada was hit with a massive external shock. There was nothing Canada could do about that, other than try to temper the impact on our domestic economy.

[Mark Adler, Conservative, York Centre, ON]

Thank you.

[The Chair, Conservative, James Rajotte]

Thank you, Mr. Adler.

We'll go to Mr. Marston, please.

[Wayne Marston, NDP, Hamilton East—Stoney Creek, ON]

Thank you, Mr. Chair. It's interesting to see the discussion at that end of the table. I appreciate it.

Many years ago, in the eighties, I was on our local labour council's full employment committee. And from labour's standpoint, if I told an unemployed worker at that time that 3%, 4%, 5% was full employment, I won't say what would have happened, but it wouldn't have been nice. I would suggest that the use of the term “full employment” in that context is a misnomer, because people think full employment should mean everybody capable of working has a job. So there's quite a gap when you think about it. As Mario indicated, we saw the acceptance of 7% and 8% as full employment, which is a real problem.

The other thing that's happening.... I fully accept targeting inflation. I'm one of the people who had a 10.25% rate in 1980 and it went to 21.75% in one jump, so you're not going to get an argument from me.

Kevin Page was before us recently, and he talked about the fact that the government side talks about 600,000 net new jobs. I'm not arguing that point, except that there are still 300,000 fewer people working than pre-recession. The news we just heard today--I think it was from Mr. Stanford--is that some 70,000 have lost their jobs in the latest figures. Well, he was predicting 100,000 for this year. So we've taken out 70,000 of that number already. We've got ourselves a very serious problem right here and right now.

I really wanted to get those points in. As for a question, does inflation targeting limit the Bank of Canada's ability to respond to the global financial crisis?

Mr. Stanford, would you like to take that one? Are there lessons that have been learned from this? Have they changed direction, or is it necessary to?

[Dr. James Stanford]

Firstly, Mr. Marston, in regard to your earlier points, we really do have a serious problem. While monetary and fiscal policy in Canada was tremendously important at the outbreak of the crisis at the end of 2008 and the beginning of 2009, we have stalled since roughly the spring of 2010. We've had no continuation in recovery in employment rates, in per capita incomes. Governments and consumers are both maxed out on their credit-fueled spending. The business sector has not kicked into gear in the way that it needs to. So we still have a problem, without taking away the value that came from that stimulus effort. The stimulus has been over for a while, and we're not out of the woods yet. We're going to need more help.

In terms of the inflation-targeting regime, it clearly did limit the Bank of Canada's ability to respond, because we were starting from such a low level of inflation in the first place. So you reached the zero bound on policy very quickly. If we had targeted inflation at a higher level or if we hadn't any target or if we just had higher inflation, they would have had more flexibility. One of the most powerful arguments against the 2% target, anyway, if not against targeting in general, is the problem that happens when interest rates get to zero.

I think that was Mr. Sumner's point as well. If the target had been at nominal GDP instead of inflation, there would be an added dimension of flexibility where the bank could have gone after it more aggressively. That being said, I think our bank was creative and committed in what they have tried to do. I don't think inflation targeting helped their effort and I think in some ways it probably constrained it.

[Wayne Marston, NDP, Hamilton East—Stoney Creek, ON]

Would anyone else like to respond?

I thought somebody might.

[Craig Alexander]

I have two points. One, on the full employment side, we don't know where full employment is. We know there is always going to be transitional unemployment. Just as anecdotal evidence, when Alberta saw its unemployment rate get down to 4%, when Calgary was in the 3% to 4% range, you started to see that they were past full employment, because that's when you started to get signing bonuses for people to hire at Tim Hortons and at McDonald's. You saw exceptional labour market challenges created by remarkably low unemployment. That was hit in the 3% to 4% range.

[Wayne Marston, NDP, Hamilton East—Stoney Creek, ON]

Also, inflation within those communities too.

[Craig Alexander]

Right. So you could see that full employment isn't zero. Let's be very clear. We don't actually know where it could be. Maybe it's not 6% to 8%; maybe it's 5% to something else.

There is another thing I would point out in terms of the conduct of the Bank of Canada's monetary policy. Ask yourself this question. How much more of a boost would the economy get if interest rates were lower? Consumers have taken on as much debt as they really can. And the problem, from a business point of view, is not the cost of borrowing; the problem is the willingness to spend and invest, because balance sheets are flush with cash.