Finance Committee on Oct. 31st, 2017

[The Chair, Liberal, Wayne Easter]

I call the meeting to order. Pursuant to Standing Order 108(2), today we have a study of the report of the Bank of Canada on monetary policy.

We have with us the Governor of the Bank of Canada, Mr. Poloz, and the senior deputy governor, Ms. Wilkins.

Welcome both, and the floor is yours. I understand you have an opening statement.

[Stephen S. Poloz, Governor, Bank of Canada]

Thank you, Chair, good afternoon. Good afternoon to committee members. Senior Deputy Governor Wilkins and I are happy to be before you today to discuss the bank's monetary policy report, which we published just last week.

When we were last here in April, we were celebrating the fact that we had upgraded our economic forecast. That was following a long period of disappointment. I'm pleased to tell you that many of the positive trends that we saw then have continued. Sources of economic growth have broadened across sectors and across regions, and the process of adjustment to the oil price shock is essentially complete.

The bank raised its policy interest rate twice since our last visit, in July and September. We did this in the context of very strong economic growth over the first half of the year and solid progress in the labour market.

Over the summer, we saw evidence of firming inflation and an economy that was rapidly closing its output gap. With these two rate increases, we have taken back the cuts we made in 2015, which were crucial in helping the economy adjust to the oil shock.

Growth in the first half of the year averaged just over 4% at an annual rate. This reflected strong consumer spending, backed by rising employment and income, together with increased business investment and a jump in energy exports. We are now starting to see signs of a moderation in the second half, which we forecast in July. Growth in consumption and investment is expected to ease and growth in housing is projected to slow further, in part because of the measures introduced by the Ontario government in April.

All told, we forecast that the economy will expand by 3.1% this year before slowing to 2.1% in 2018. This is still faster than the growth rate of potential. We estimate that the economy is now operating close to its capacity. Inflation should reach our 2% target in the second half of next year. That's a little later than we projected earlier because of the temporary impact of the stronger Canadian dollar this year.

We're at a crucial spot in the economic cycle and significant uncertainties are clouding the way forward. In our MPR, we identified the four most important sources of uncertainty, and I'll just touch on those now.

The first source of uncertainty is inflation itself. There have been several conjectures about the apparent softness of inflation in Canada and in many other advanced economies. Some have argued that globalization is restraining inflation. This could be due to increased imports from lower-cost countries, for example, or the effect of Canadian companies participating in global supply chains. Others point to the impact of digitalization on the economy. They suggest that digital technologies could lower barriers to entry in some sectors and lead to more competition. The rise of e-commerce may be changing price-setting behaviour, and digital technologies could promote innovation and higher productivity, which could create disinflationary pressure.

The second source of uncertainty is the degree of excess capacity in the economy. We note several signs that point to slack remaining in the labour market. For example, the participation rate of young workers is still below trend and average hours worked are less than we would expect. With the economy now operating close to capacity, we expect to see investment by companies, together with job creation by new and existing firms, and rising productivity. This should serve to raise the economy's potential output, increasing the amount of non-inflationary growth that is possible. However, this process is highly uncertain and not at all mechanical, so we have built it into our projection in a conservative way.

The third issue is the continued softness in wage growth. While employment growth has been strong in Canada, wages have not kept pace. The slack in the labour market is certainly responsible, in part, for this effect and there will be a lag between the time the slack is used up and when we see stronger wage growth. However, other factors, including globalization, may also be affecting wage dynamics.

Finally, the fourth issue is the elevated level of household debt and how that might affect the sensitivity of the economy to higher interest rates.

Bank staff have recalibrated our main economic model used for projections to capture key information about housing and debt. This work tells us that the economy is likely to respond to higher interest rates more than it did in the past. However, we will watch incoming economic data closely for evidence to support this idea. We will also look to see how the household sector is responding to the new rules about mortgage underwriting.

We also outline several other risks in our MPR. Taken together, these give us a balanced outlook for inflation. We have not incorporated into our projection the risk of a significant shift toward more protectionist trade policies in the United States, given the range of potential outcomes and the uncertainty about timing. However, we acknowledge that uncertainty about future U.S. trade policy is having some impact on business confidence now and on investment spending as well, and this impact is reflected in our outlook.

In this context, governing council judged that the current stance of monetary policy is appropriate. We agreed that the economy is likely to require less monetary stimulus over time, but we will be cautious in making future adjustments to our policy rate. In particular, the bank will be guided by incoming data to assess the sensitivity of the economy to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.

As this is a very important message, allow me to repeat it.

In this context, governing council judged that the current stance of monetary policy is appropriate. We agreed that the economy is likely to require less monetary stimulus over time, but we will be cautious in making future adjustments to our policy rate. In particular, the bank will be guided by incoming data to assess the sensitivity of the economy to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.

With that, Mr. Chairman, Senior Deputy Governor Wilkins and I would be happy to answer questions.

[The Chair, Liberal, Wayne Easter]

Thank you very much, Governor.

For the committee's information, we'll go until about 4:53 in this session. Because the committee business could take a little time, we're going to move it up in between the Governor of the Bank of Canada and the parliamentary budget officer and allocate 15 minutes there. We might not need it, but that should give us enough time.

We'll start with Mr. Fergus for seven minutes.

[Greg Fergus, Liberal, Hull—Aylmer, QC]

Thank you very much, Mr. Chair.

Mr. Governor, Madam Deputy Governor, thank you for being here.

Since I have been on this committee, this is the second time that you have appeared before us, and I am delighted about it. I would first like to congratulate you for your work in guiding our economy and our monetary policies.

My question is about the consumer price index. It must be more and more difficult for you to know which basket of goods and services to examine in order to establish the rate of inflation. In this modern era, is it much more complicated than 15 or 20 years ago?

[Stephen S. Poloz]

Fortunately, that is up to Statistics Canada.

I will let Ms. Wilkins give you more details.

[Carolyn A. Wilkins, Senior Deputy Governor, Bank of Canada]

I believe that Statistics Canada tries to have a basket that represents goods and services consumed by Canadians. Statistics Canada tries to weigh those goods and services dynamically, because it changes over time, although not on a daily basis, according to the way in which they investigate how consumption standards change. That is what Statistics Canada does.

Our task is to explain the process of inflation, which could well be influenced by globalization as well as by digital technologies. In fact, many more goods and services are sold on the Internet, thanks to e-commerce. A number of goods are imported from countries that have a different productivity rate than ours, which could influence the dynamics of inflation.

In our monetary policy report, we try to study it in more depth. At the moment, we see little evidence indicating that the dynamics of inflation have changed a lot in Canada. We can certainly explain that with our standard tools, but we are keeping an open mind, because, with more data and with more experience, we may well find more factors.

[Greg Fergus, Liberal, Hull—Aylmer, QC]

I noticed that you use a combination of different kinds of baskets to calculate the inflation rate or the consumer price index, the CPI. You weigh it all differently.

Does Canadian geography pose a problem for you, in that the basket for the east of Canada is not the same as the one in Toronto or in the regions of Quebec?

[Stephen S. Poloz]

Yes, there are differences between the various regions of the country. The main differences are in the cost of housing. The inflation rate does indeed vary with the large cities in the country. When there is a migration to other regions, there has to be a period of adjustment. For example, in Toronto, the cost of housing is going up more quickly than in Calgary. The two inflation rates differ during the adjustment period, reflecting the real cost of living in those cities.

For the most part, the indices seem to be the same for the products traded across the country. As I often say, the differences are in housing and haircuts.

But the other things are very interchangeable.

[Carolyn A. Wilkins]

In some regions of the country, like the north, price dynamics can be influenced not only by supply and demand, but also by sporadic changes in transportation costs, for example, which influences all the goods and services that have to be transported. That is another example showing how the inflation rate can vary in the country.

[Greg Fergus, Liberal, Hull—Aylmer, QC]

The burning question is about the very high level of Canadians’ debt. In the best case, how could we adjust the Bank of Canada policy rates in order to reduce Canadians’ debt, but without setting rates so low that Canadians would go more into debt or be tempted to do so?

[Stephen S. Poloz]

That really is a question of balance.

Our objective is to have another target for inflation. We have no other tools with which to adjust the specific consequences. However, we are certainly aware of the factor as we try to achieve a balanced interest rate.

As I mentioned earlier, we have adjusted the models to include the fact that the level of debt increases the economy’s sensitivity to changes in interest rates. That is one of the key questions that we have studied very carefully. It is why we will be prudent with the adjustments we make in the future.

[The Chair, Liberal, Wayne Easter]

Thank you.

I'll turn now to Mr. Poilievre.

[Pierre Poilievre, Conservative, Carleton, ON]

Thank you, Governor and Deputy Governor.

You identify in your report, as one of the risks, that Canadian households are taking on high levels of debt. These levels, in relation to income, are among the highest in the developed world. You have publicly spoken about the dilemma you face, that if you raise rates to discourage more borrowing, you may ultimately cause stress and strain on existing households, given the debt levels they already have.

How much of an interest rate increase could households absorb, given their existing levels of indebtedness?

[Stephen S. Poloz]

Certainly, the risk you're discussing is one that's foremost in our minds and has been for quite some time. The elevated household debt not only poses this challenge about how interest rate adjustments occur, but of course actually represents an ongoing vulnerability of the economy to other shocks, such as a new global recession out in the world. What happens is that high levels of debt act as an amplifier. They make the shock have a larger effect on the economy than it otherwise would.

For example, let's say there was a recession in the United States. The sequence would be that unemployment in Canada would rise, folks would have difficulty keeping up with their mortgage payments, and that would cause bigger cutbacks in spending than we otherwise would have.

We have always known that this would be, if you like, a second-order consequence of the primary objective, which is to get the economy back on track, get the economy back to our 2% inflation target, which means full employment. That is the best contribution that monetary policy can make to ensuring that in the long term, these debts are sustainable and serviceable. The fact is that given the shocks we've been through since 2007....

I remember that in 2008 every country in the G20 cut interest rates very low and had a large fiscal expansion in order to offset the consequences of the global recession. I think, too, this was an unqualified success. It certainly averted what I think we all would be calling by now “the second great depression”. All the ingredients were present.

By 2010, it looked as though we had most of the bad news behind us, so fiscal consolidation began to emerge as a priority in lots of countries, but as it turned out, the world delivered a bit of a slowdown, which progressed, and interest rates needed to stay low longer, so we have these consequences of higher debt.

I just want to assure you that we take this fully into account and will be monitoring how households are reacting to those debt levels and interest rates. It's not a simple arithmetic calculation about what they can absorb. The economy will moderate, compared to the levels we have seen, as this process unfolds.

[Pierre Poilievre, Conservative, Carleton, ON]

In a section of your report entitled “Risks to the Inflation Outlook”, you also identify, on page 28, a larger impact of structural factors and prolonged excess supply on inflation. In that section, you also talk about the possibility that housing prices may drop.

If that were to occur, the collateral against which household debt is secured would be reduced in value. How much risk does that pose to financial institutions or to the insurers that back up those institutions?

[Stephen S. Poloz]

It's exactly one of the scenarios that we considered carefully and have analyzed in some depth.

In our FSR, the financial system review, where most of this risk assessment takes place, we consider risks that have large drops in housing prices, much larger than one could anticipate along with a recession. In other words, the recession causes the housing prices to fall, so the economy has a double layer of shocks on it. In scenarios even as grave as this, the financial system remains highly robust.

It's true that collateral against which people have borrowed is reduced in value, but the financial system itself is very well provisioned against shocks of this sort. Of course, the new Basel accord brings us into that zone. Canada has not had to adjust much to those new accords because we've always had a more robust provisioning system than in many other countries. As a result, we're confident that the financial system itself is not a source of risk, but we consider these to be vulnerabilities, which are more likely, as I was describing a moment ago, to magnify the impact of shocks on the economy.

Carolyn, did you want to add anything to this?

[Carolyn A. Wilkins]

I would just add, aside from the fact that our banks are highly liquid, capitalized, and diversified, there have been other measures aside from interest rates. We've talked a lot about the role of interest rates, but there's a role for macroprudential policies as well.

OSFI, last fall, and then most recently this fall, has taken moves to improve the quality of debt that's out there by providing clarified guidelines to financial institutions that are lending to households about what kinds of criteria they should put in place to make sure the household can withstand increases in interest rates. Here I'm talking about the new stress tests that they put in.

What they did last fall was aimed at the insured space. In the data, you can now see that the share of households that are very highly indebted—those are households that have a loan-to-income ratio of over 450%—has fallen from about 18%, to a little less than half of that now. What they did this fall, most recently, was to look at the insured space—that's quite a growing area—and applied very similar kinds of tests there. It's too early to say what the effect is going to be on that, but over time it will improve the quality of debt so that it will be more resilient to the shocks that the governor was talking about.

[The Chair, Liberal, Wayne Easter]

We'll go a little over the time, because I think the answers require a fairly in-depth discussion.

Go ahead, Mr. Poilievre, the floor is yours.

[Pierre Poilievre, Conservative, Carleton, ON]

That's greatly appreciated, Mr. Chair.

Madam Vice-Governor, you mentioned the macroprudential measures that OSFI has instituted for mortgages that are low loan-to-value; that is, where down payments of greater than 20% are made.

I met today with mortgage brokers who made the point—a point that was also made in the Globe business report earlier this week—that these measures, combined with the uninsured nature of higher down payment mortgages, in many cases lead to higher interest rates for those with bigger down payments than they would pay if they made smaller down payments. That creates a strange perverse incentive to put fewer dollars down on one's house.

I think all of us would agree that we should be promoting bigger down payments because they're less risky to the system and to the borrower.

Do you worry at all about some perverse incentives that may result from OSFI's recent regulations?

[Stephen S. Poloz]

What in fact is happening there is that if your down payment is less than 20%, the rules dictate that it must be insured. A mortgage loan which is insured is, of course, a lower risk to the financial institution, so generally it's possible—it's not necessarily the case—that you'd have a lower rate of interest on that.

However, the borrower must pay for the insurance—it's not zero cost, it's actually quite a significant cost—which is rolled into the upfront value of their mortgage, so they are paying for it in a different way. Those folks who have more than a 20% down payment then go to an uninsured mortgage. It's possible that their interest rate will be a few tenths higher, but they're not paying for the insurance, which is a pretty big upfront cost.

I think, in that sense, there's no perverse thing in the space around the decision, and it's a stretch to create a case where you're actually better off in the first case.

[The Chair, Liberal, Wayne Easter]

Mr. Dusseault, go ahead.

[Pierre-Luc Dusseault, NDP, Sherbrooke, QC]

Thank you, Mr. Chair.

My thanks to the governor and the senior deputy governor for being here.

I was also thinking of spending time on the matter of household debt, but I feel that it has been well covered.

So I would like to go back to the relationship between two curves that, in my opinion, can be linked. They are the salary increases in Canada, or rather, as you said, the salaries that are basically stagnant, and inflation. Those two items can be linked because Canadians see increases in the inflation rate, and for basic products, but they also see that salaries are not increasing at the same rate.

Do you see that as a long-term problem for the Canadian economy? Do you have any data on those two issues and the relationship between them?

[Carolyn A. Wilkins]

That is a very interesting question because we are focusing a lot on salaries. It is one of the indices that we are examining to determine whether the pressures on inflation are upwards or downwards.

For salaries, using a number of sources, we can see that the increases are quite small, as you said. In addition, as you can see in figure 2 in the monetary policy report, we have tried to go into the issue a little more deeply. We have seen that we can explain a part of the weakness in salaries by the shock caused by the drop in petroleum prices that we have experienced. That brought about a change in a sector where the jobs came with salaries that were high when compared to other sectors, such as services, where salaries are lower.

In addition, the adjustments in the energy sector itself required small salary increases, and that continues. If you combine that with the labour market indicators, where supply exceeds demand, you can see that salaries are lower at the moment. However, we expect that, as the economy continues to grow, salaries will continue to rise. So there should then be an increase in those rates over time. However, the pressures on inflation coming from the labour market mean that the price of goods and services is lower than it would otherwise be.

[Pierre-Luc Dusseault, NDP, Sherbrooke, QC]

Thank you. Some public policies at provincial level could perhaps help to increase salaries in general.

As for interest rates, the policy rates have increased, as you have clearly explained. I was wondering if a link can also be made with the federal debt, which is increasing, as we know. Everyone is aware of the recent economic statement. Do you consider public finances as a problem for Canada? Interest rates are increasing, which also means an increase in the costs of the debt.

[Stephen S. Poloz]

At the moment, we still really have no budget for 2018. We only know the items that the Minister of Finance mentioned would be added to the budget. That is why it is not possible for us to analyze the net consequences of the debt on the budget before it is introduced. In fact, the Bank of Canada incorporates tax exemptions only when the budget becomes law. We do not add them when they are simply announcements.

More generally, it is our hypothesis that the relationship between the debt and the economy is going to continue to decrease slightly. It is at a very low level in comparison with a number of other countries. In that sense, it is not really a major concern.