Finance Committee on Nov. 4th, 2014

[Stephen S. Poloz]

You're absolutely right, and you premise it well. If it weren't for these low interest rates and the policy response back in 2008, we could be in the second great depression right now.

People should bear that in mind when they ask why interest rates aren't up where they need them to be. The answer is that the headwinds remain significant and we're still pushing against them in order to create what we do see. Obviously the U.S. economy is not in equilibrium even though it's growing at perhaps 3% and interest rates are zero. It's mostly induced growth, not natural, so we have to wait for that to happen.

Where we're going to end up is a question of what we call the neutral rate of interest. Carolyn did an important piece on that and gave a speech on that, so I'd like her to elaborate.

[Carolyn Wilkins]

Sure, Governor.

One thing we look at, which the governor alluded to, is where we think the neutral rate of interest is. That's the short-term, risk-free interest rate. It's basically that the difference between that and our actual policy rate measures the degree of stimulus.

However, it's also important for investors and others to know where that is because it's where we think in the medium term we would be once the output gap is closed, inflation is back at target, and all of the headwinds have dissipated, or all the effects of shocks, as the economists like to put it, have dissipated. That's what's going to tie all of the other rates of return.

What one needs to keep in mind is not only where we are in terms of the cycle, but also where we are in terms of bigger structural changes globally. In Canada, that rate is going to be influenced by that. What we're seeing are the demographic changes that are occurring not only in Canada but globally. That means that global potential output growth is slower than it was in the early 2000s. That means the returns to interest are likely to be lower.

You have all of these factors, and you have global savings that are higher, so we're going to see lower rates than what we've seen in the past for a pretty long time.

[Dave Van Kesteren, Conservative, Chatham-Kent—Essex, ON]

There was an interesting case in Germany where one of the banks had charged a negative rate. I hope we don't see that in Canada. I don't expect that to happen.

We have had some interesting discussions here too.

I want to talk to you about austerity. I want to talk to you about whether that is something we should pursue. I'm thinking not so much in terms of the infrastructure; most of us probably would agree that infrastructure is something that will contribute to the overall growth of the economy. However, in terms of governments managing and not spending in areas where.... Let's take as a simple illustration an office that was making a foot of paper and we reduce that to a half. There are those—and I was witness to that at the recent OECD conference—for whom austerity was something that was not only frowned upon, but governments were asked to back away from. It would appear to me—I don't remember the philospher's name from the 1900s, but it's a story about the broken glass. I'm sure you as an economist know which one I'm talking about. Isn't that something that we are meddling in, if we don't encourage that kind of austerity? That certainly can't be something that's going to contribute to growth in the economy. Wouldn't you agree?

[Stephen S. Poloz]

Austerity as a principle I think has an important foundation, but one has to qualify it by the context you find yourself in. My own sense of it is that the more important thing, and I mentioned this earlier, is to have a credible plan around the fiscal future. That is what markets find reassuring. It's what taxpayers find reassuring.

Given the context we found ourselves in, almost every government on earth in 2008, 2009, and 2010 found that it would be the wrong day to practise austerity. That's a good thing, because as I said before, we had all the ingredients of a second global depression there and we avoided it through smart policy-making.

What the debate enters into is when is the right time to get things back on track. Given the cycle, it is possible to figure out whether, cyclically adjusted, you are still on an austerity plan. I think that's the OECD method of figuring out where you are relative to your plan. You may have a fiscal deficit, but if you adjust for the business cycle in your economy, actually it's a cyclical or cyclically adjusted structural surplus or balance, which means that your plan is on track. I think that kind of tool is very helpful to help others understand what is the net effect on the economy. We're not experts on that. We take that as an input to our forecast.

Just to give more of a round thing around that question, you simply can't look at it as the knife edge: do we practise austerity today or do we wait one more year? Those are questions that boil down to how every country is different and every situation is different.

[Dave Van Kesteren, Conservative, Chatham-Kent—Essex, ON]

Very quickly, I want to shift gears. It has been brought up a number of times about the spectrum rising with the oil prices dropping. I for one believe that most of this is brought on by the Saudis and their policy. Which group do you think is more vulnerable, the shale oil or the oil sands? Have you done a study on that?

[Stephen S. Poloz]

Roughly speaking, they seem to be similarly vulnerable. Of course, in each of those fields, you have various break-even points in the price spectrum, so you can't generalize, really.

The fact is that this lower oil price is a product not just of the supply effect, that is, extra supply, but also around a third of the decline, we'd guess, is because there has been an easing off of global demand. Both of those things are contributing in the same direction, and it's why it's so hard to forecast and why we simply choose not to. We choose to adopt a convention and then shock our outlook around that price. Right now, we think we'll get up to $85. That's our analysis.

[The Chair, Conservative, James Rajotte]

Thank you, Mr. Van Kesteren.

We'll go to Mr. Adler, please.

[Mark Adler, Conservative, York Centre, ON]

Thank you, Governor and Senior Deputy Governor, for being here today.

I want to quote Ms. Wilkins. You made a speech, Mr. Poloz, that you've referred to a number of times during your presentation today, and you said, “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.”

Given that quote, how significant a decision was it by our government when we assumed power in 2006 to pay down $30 billion in debt? Could you answer that? Also, how significant is it that, of the G-7 countries, we are going to have the first balanced budget in 2015?

[Stephen S. Poloz]

As I said earlier, I think throughout that piece the good news was that we had the flexibility to be able to respond to a very adverse development. It's one of the ingredients that helped Canada to have a better great recession than other countries, and then what really made it clear to markets that everything was on track was the credible fiscal plan that came with it.

I would leave my comments at that, but those ingredients were helpful to markets and of course to the economy at a time when exports fell very dramatically. That's the most important growth ingredient of our economy ongoing. Low interest rates combined with some fiscal action made the difference.

[Mark Adler, Conservative, York Centre, ON]

Deflation on the global scene is certainly not a problem in emerging economies, but may be a problem in some of the rich nations' economies, if you will. How much of a threat is the deflation and what problems may that pose for Canada?

[Stephen S. Poloz]

Deflation is a significant threat.

When it arises we get falling prices interacting with existing debt loads making debt burdens go up uncontrollably. That combination makes them very difficult to deal with. We've seen in Japan since 1990 this ongoing struggle with the downward forces coming from deflation occasionally going away but always coming back. It's the sort of place that we don't want to go ourselves. Of course it means that if it's a problem elsewhere, since we're part of the global economy, it has impacts on us.

For instance, given the situation we're in here in Canada, it's why we would say here in our monetary policy report that the forecast risks around our plan for inflation are balanced. If there were an upside risk, we would realize that's a lot easier for us to deal with than if there were a downside risk. A downside risk is harder to deal with because we don't have much room to manoeuvre as a monetary policy-maker ,whereas on the upside risk we know exactly what to do. There's an asymmetry in there. That's why policy-makers are so preoccupied with downside risks in this environment.

[Mark Adler, Conservative, York Centre, ON]

Monetary policy is somewhat of an exercise in risk management, if you will. I'm curious. We know some of the potential pitfalls on the global scene. Perhaps this is an unfair question. What do we know that we don't know? In other words, are there any potential pitfalls on the global scene that the bank is keeping an eye on that others may not be?

[Stephen S. Poloz]

There are an awful lot of things that we know we don't know. Let me select a couple that I find most concerning.

We always talk as if we know what our output gap is here in Canada, what we should do, and what the consequences from inflation would be. That is subject to a lot of different methodologies and a wide range of possible estimates. We talk about financial stability issues, which Carolyn may wish to speak to. What's your biggest concern on the financial stability front that you don't know?

[Voices]

Oh, oh!

[Carolyn Wilkins]

I guess it's where to start?

The biggest concern is it has to be domestic so it has to be the housing sector. What we don't know is, given the strength seems to be concentrated in cities where you can have reasonable explanations why it's very strong—Toronto, Calgary, or Vancouver—there are underlying structural reasons that you would expect those markets to be strong. We don't know for sure the extent to which there may be overbuilding and overvaluation. We don't know why overvaluation builds and what can trigger it to unravel. That's a thing that worries me domestically.

[Stephen S. Poloz]

I'll just put some icing on that cake, if I may. That is, we don't know what this new global financial architecture is doing. We think it's very important to enhance the resiliency and the safety of the financial system. We rely on the financial system every day to make the economy move, so we need a whole new cycle to live through before we'll understand that.

[Mark Adler, Conservative, York Centre, ON]

Our government is moving aggressively. We talked earlier about international and bilateral trade agreements, but we're moving more aggressively on the internal trade barriers too.

How important would that be to break down those internal trade barriers?

[The Chair, Conservative, James Rajotte]

May we have a brief response, please.

[Stephen S. Poloz]

It would be fantastic if you were able to remove internal trade barriers. It would probably have more of an effect on Canada than the external trade barriers.

[The Chair, Conservative, James Rajotte]

Thank you, Mr. Adler.

I'm going to ask a few questions as the chair.

First of all, the U.S. Fed has announced it is moving away from its nearly six-year policy of quantitative easing. What impact will that have from your perspective?

[Stephen S. Poloz]

QE, quantitative easing, was, of course, something we always knew was in the central bankers' tool kit. We always hoped we'd never have to pull it out. It was pulled out in the U.S. to big effect. The jury's still out on measuring the actual effects, but I'm confident that it did have an important boosting effect on the U.S. economy. Certainly it had an effect on long-term interest rates, which matter. It had an effect on confidence, which also mattered quite a lot.

It's important to bear in mind that QE is not over in the sense that all the expansion of the Fed's balance sheet remains in place; they have just stopped adding to it. That's because they can see that the economy is getting traction of its own and that it's self-sustaining, so it's unambiguously good news for us that QE is coming to an end. It means that in their judgment, there is good momentum in the U.S. economy, and that matters a great deal to us.

[The Chair, Conservative, James Rajotte]

I appreciate that.

I want to return to the issue of business investment, which has been raised by a number of colleagues here. As you point out, businesses do have healthy balance sheets. I think it's fair to say that's in part due to corporate tax reduction policies.

From a number of presentations by you and others regarding the lack of business investment, it seems to me there are two reasons: one is uncertainty, and the other is the reason you outline on page 21 of your report. I'll come to that later.

With regard to uncertainty, you'll never find a period in human history when world affairs are completely certain. Also, a market economy is by its very nature dynamic and therefore uncertain. I have to say that personally, I'm not that sympathetic to the uncertainty argument. You can comment on that in your answer.

With respect to your response on page 21 with respect to reasons for not investing, you say that “most sectors expected to lead the recovery in non-energy exports currently have sufficient excess capacity to meet demand”, so therefore they don't actually need to spend to actually meet the current demand. You point out that we therefore need exports to increase. You obviously link that to the value of the Canadian dollar.

I want you to comment on that from a business investment point of view. Then I want to tie it into another issue, which is that some observers have said that the bank is moving to actually account for more factors in terms of what it's doing. Traditionally the role has been simply to target inflation. Many people have said that since you have become the governor, you've moved more into looking at things like the value of the Canadian dollar and exports, in terms of what the bank is doing, so you're actually expanding the bank's role beyond the strict monetary policy of inflation targeting.

I'm wondering if you can address the business investment point, and then the point about whether the bank's role is expanding and should expand to take into account trade, the Canadian dollar, and other such matters.

[Stephen S. Poloz]

Sure. Thank you.

To speak to the uncertainty point, you're absolutely right that there has never been a time when there wasn't uncertainty. Companies get used to taking business decisions in an uncertain environment. A lot of things about this business cycle are unusual, which make it more difficult and therefore hard to measure, and I would argue, much more uncertain, especially looking to the future rather than in the past.

Of course, you can get that by asking them directly what they are actually seeing. The answer often is that they're not sure or they don't know. You can see in their actions what kinds of investments they make. There are investments to modernize or cut costs or remove impediments to productivity as opposed to those to expand.

If we go a little bit deeper, our model suggests that as the economy accelerates, investment accelerates, so it compounds the acceleration. That's why we call it the accelerator model. Well, it's not really working yet. When we ask the deeper question of why, we find that the companies that are experiencing the increased flow through the exports sector say they still have room to grow without investing in more capacity. Not everyone says that, but many do.

That means they can accommodate those higher orders without expanding, and they don't have to add more people either. Measured productivity goes up, which is not a bad thing, but we have to be a little more patient until we get the rest of the follow-through.

Tying that to the second half of your question is very important. The Bank of Canada has only one goal, and that's to keep inflation on its target within a timeframe of around six to eight quarters. That's our horizon of flexibility.

We perceive that to be totally consistent with the other goal that people often mention, which is that the economy needs to be operating at its capacity, at full employment, and those things. Other central banks like the Fed have a dual target: they're responsible for inflation and for employment. To our mind, there's no inconsistency between those two things because getting inflation to be stably and reliably at 2% will require that we get the economy to its full employment level. Otherwise it will drip down and we'll miss our target. Those things are consistent.

We're saying this cycle is different in the sense that it's more prolonged, and we have to look more deeply at some of these reasons to understand them better. That's why we have to behave differently from how we would if we just said inflation is at 2%, so it's fine.

[The Chair, Conservative, James Rajotte]

Okay.

I have only a minute left in my time. You talked about the labour market. Can you address the regional differences in the labour market? Alberta, and perhaps Saskatchewan and even Manitoba, are very much different from other regions in Canada.

Just give a brief response to that.

[Stephen S. Poloz]

Absolutely.

Very briefly, it's important to bear in mind that even though oil prices have come down recently, the rise in oil prices from around the lows of $25 or $30 to say, the $75 to $100 zone or something like that is the big shock of our times. The underlying structural adjustment gives rise to more job creation in energy rich provinces and a lower-speed economy in the others. As a result, we get a regional divergence in employment patterns and housing patterns. All those things are totally predictable from our basic economics.