Industry Committee on Jan. 30th, 2008

[The Chair, Conservative, James Rajotte]

Members, I welcome you to the 15th meeting of the Standing Committee on Industry, Science and Technology. This is continuing our study, pursuant to Standing Order 108(2), of the impact of the appreciating value of the Canadian dollar on the Canadian economy.

We have two panels before us today, for an hour each. We have very special guests here for the first panel; we have witnesses from the Bank of Canada. First of all, we have Mr. Paul Jenkins, senior deputy governor. Secondly, we have Mr. John Murray, a deputy governor.

Gentlemen, welcome. You have up to ten minutes for your opening statement. Then we'll go right to questions from members for one or two rounds.

Mr. Jenkins, I believe you'll be starting.

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

Thank you very much, Mr. Chairman.

We are pleased to be here with you today. We hope we will be able to help your committee as it examines the impact of exchange rate movements on the Canadian economy. As you noted, with me is John Murray, who has recently been appointed as a deputy governor and also a member of the bank's governing council.

To begin, as background I would like to quickly review the framework within which we conduct monetary policy in Canada. The Bank of Canada Act calls for us to mitigate fluctuations in the general level of production, trade, prices, and employment so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada.

Over time we have learned that the best way to fulfill this mandate is to keep inflation low, stable, and predictable. Specifically that means we aim to keep the annual rate of inflation as measured by the consumer price index at 2%. To keep inflation on track, we aim for a balance between total demand and total supply in the Canadian economy. By maintaining low and stable inflation, our monetary policy helps to keep the economy operating at full capacity and promotes greater stability in economic output.

Let me also stress that a stable economy operating at full capacity also has the additional crucial benefit of helping the economy to adjust to changing circumstances.

What does all this have to do with the exchange rate? Well, the exchange rate of the Canadian dollar is a key element of our monetary policy framework. Without a floating exchange rate, we would not have the ability to conduct an independent monetary policy appropriate to our domestic situation. This means that we do not have a target for the Canadian dollar, but the exchange rate is an important relative price in our economy, and we pay very close attention to it and to its movements.

Movements in the exchange rate influence the level of imports and exports, which can help to keep total demand and supply in balance and have a direct influence on price levels in our economy. Further, exchange rate movements act as a signal, if you like, to shift resources into sectors where demand is strongest. Our floating exchange rate helps to facilitate this process.

That said, we recognize that these types of adjustments can be and indeed have been difficult for some sectors, regions, and communities.

When the Canadian dollar rises or falls, we try to determine the degree to which those movements are due to changes in world demand for our goods and services, and how much is due to other, unrelated factors. It is important that we understand the causes of exchange rate movements, because the implications for the economy — and the appropriate monetary policy response — depend on the reasons for the change. We must then incorporate this information with our assessments of our monetary policy that works to keep total demand and supply in balance.

Exchange rate movements can also be, as we have seen recently, quite volatile. That has sometimes led to calls, for example, for Canada to fix its currency to the US dollar. That would be a mistake. The United States are certainly our closest neighbour and by far our largest trading partner. But the structures of our two economies are very different. This means that each of us often requires different adjustments and different policies in reaction to shocks. Canada's floating exchange rate helps in this process by acting as a shock absorber.

Mr. Chairman, we cannot avoid adjustment. The question is, how can we best adjust to changing global and domestic economic forces? With a fixed exchange rate, the adjustments would have to come through movements in overall output and in all wages and prices. History has shown that those adjustments are more protracted and more difficult when the nominal exchange rate is not allowed to move. Again, however, I stress that this does not mean that the Bank of Canada is indifferent to movements in the exchange rate.

Let me conclude with a few summary comments on our latest monetary policy report update, released last week. I believe copies have been made available to committee members. In this report we said the Canadian economy continues to operate above its production capacity despite some slowing in growth in the fourth quarter of 2007. The bank projects that economic growth in 2008 will be weaker than was expected in our report last October, averaging a little over 1% in the first half of this year and a little over 2% in the second half. On an annual average basis, the economy is projected to expand by 1.8% this year, in 2008, and 2.8% in 2009. Both core and total CPI inflation are projected to fall below 1.5% by the middle of this year before returning to 2% by the end of 2009.

On December 4 and again on January 22, the bank lowered its target for the overnight rate by one-quarter of one percentage point, bringing it to 4%. We also said in our report, in line with the bank's outlook, that further monetary stimulus is likely to be required in the near term to keep aggregate demand and supply in balance, and to return inflation to target over the medium term.

With that, Mr. Chairman, John and I would now be happy to take your questions.

Thank you.

[The Chair, Conservative, James Rajotte]

Thank you very much, Mr. Jenkins, for that presentation.

The first round will be for six minutes. We will begin with Mr. Simard.

[Raymond Simard, Liberal, Saint Boniface, MB]

Thank you very much, Mr. Chair.

The disadvantage of being first is that you don't get the benefit of hearing everybody else's comments, and this was a very short presentation.

I do have a few questions, though. One of them is with regard to the different sectors and the adjustment periods, for instance, for the manufacturing sector and the service sector. We've been hearing about manufacturing sector woes for a little while now, and we've realized that over the last 10 or 12 years they've had some pretty good economic times. They haven't necessarily made the adjustment for the possibility of an increase in the dollar. I wonder if you can tell me, and I'm not sure, maybe this is an opinion, where are we in terms of the adaptation? Are we half-way through? Are our companies adapting? Are they not taking this seriously, or are they moving towards a full adjustment to the dollar at par?

[Paul Jenkins]

That's a very good question. I'll apologize because I know we don't have a great deal of time, but I think this really is a very important issue you've raised.

Let me start off by saying, first of all, that what we have seen in terms of the adjustment taking place in the Canadian economy has actually been further along than we might have expected, based on history. If you go back to the seventies and eighties, for example, we were not very good at adapting to changing circumstances. When you look at what has happened in the Canadian economy more recently, we've actually been pleased with the adjustment that has taken place. That's not to say the adjustment hasn't been difficult, but adjustment has been taking place. Certainly, based on the information that we gather through our regional offices--we produce four times a year what we call a business outlook survey and we actually go out and talk to businesses and we ask them how they are progressing--the evidence is encouraging. Can I say whether we're half-way through it or three-quarters of the way through it? That's harder to say, but all the evidence would suggest that this adjustment is taking place, as difficult as it is in certain sectors.

I think it points to a broader issue you've touched on, and that broader issue is the importance of continuing to move in the direction of increase in the degree of flexibility in the Canadian economy. With respect to the types of shocks that we've been experiencing--you talked about the last 10 or 15 years--if you go back and you trace through those shocks, going back to the Asian crises and the Latin American crises and the debt problems in Russia, the collapse of the high-tech bubble, SARS, and more recently the emergence of countries like China and India--these two countries alone account for 40% of the world population--these aren't going to go away. We need to continue to work very hard at continuing to improve the flexibility so we can make sure that adjustment is quick and as painless as possible.

[Raymond Simard, Liberal, Saint Boniface, MB]

I'm actually surprised to hear that you do consult companies to see where they are. I didn't think you used that kind of tool.

Another question was on what tools you utilize prior to making interest rate decisions. That's one of them, obviously.

I'd also like to touch on the sub-prime mortgage crisis in the States, again in terms of where you think it is along its path. We've had substantial writeoffs by some of the biggest banks in the world. Again, are we 50% through, are we 75% through? I know it's a tough call, but it's important for us to know that. I have an investment portfolio, and I'd like to know if I should be investing or not.

[Paul Jenkins]

As a central bank, we try not to give personal advice.

[Raymond Simard, Liberal, Saint Boniface, MB]

And how low are you prepared to go in terms of reducing your interest rates?

[Paul Jenkins]

Well, that's another tough question. But again, that's another very good question. It is difficult to say how far along we are in that process. Let me cut into it in one particular way and see if this is helpful. Then I'll ask John to pitch in, because he spends a lot of his time thinking about the global situation, including, of course, the United States.

We obviously, in thinking about Canadian monetary policy, have to pay a great deal of attention to what goes on outside Canada, whether it's in the United States, China, India. In the case of the United States, as I noted in my opening remarks, it remains our major trading partner, but the structures of our economies are different.

Clearly, we see a very direct impact on the Canadian economy as a result of the sub-prime mortgage situation. It comes, in the first instance, through the decline in residential construction, and therefore the demand for lumber, doors, windows. You can go through the list of products that we export.

When we put together our view for the Canadian economy, which influences directly our decision-making process, we have to have a view of the United States. In our monetary policy report of last week, which you have a copy of, we've actually adjusted down, quite significantly, the U.S. outlook. We have growth in the United States in the first half of this year of only 0.5% at an annual rate. We do see it picking up in the second half of the year. Behind that, we have a further significant decline in residential construction this year in the United States, and we see some further decline next year. So we still have some way to go.

Then the other leg to this, of course, is the financial leg and the implications of this for losses, the writeoff in recognition of those losses, and the recapitalization of bank balance sheets.

John, do you wish to add a few comments?

[The Chair, Conservative, James Rajotte]

Mr. Murray, be very brief, if you can. We're over time here.

[Paul Jenkins]

I do apologize. We'll shorten our replies.

[The Chair, Conservative, James Rajotte]

Just very briefly, Mr. Murray.

[John Murray, Deputy Governor, Bank of Canada]

I'll be very brief.

Just to add a footnote to what Paul said, we don't expect the situation in the U.S. housing sector to normalize until the latter part of 2009. That's not to say, though, that we don't see the U.S. economy beginning to turn through 2008 because of the strength in other sectors. The two weakest quarters, we think, are in the front half of the year, after which we see it beginning to grow based on strength elsewhere.

[The Chair, Conservative, James Rajotte]

Thank you, Mr. Simard.

We'll go now to Madame Brunelle.

[Paule Brunelle, Bloc, Trois-Rivières, QC]

Welcome, Gentlemen. It is a pleasure to have you with us.

Over the last few months, there was a lot of talk about the high dollar, its fluctuations, obviously, high energy prices and the impacts of that on the manufacturing sector.

In your crystal ball, do you see many more job losses in the manufacturing sector? Is it true that the high price of energy boosts the dollar, as people say?

[Paul Jenkins]

Obviously, the prices of energy products and other commodities are high due to global demand, especially from emerging countries.

In our monetary policy update, we use future contracts to estimate energy prices, which reflect the market consensus. Roughly, the price of energy in future contracts is around $90 a barrel, which is pretty high.

As I already said, the adjustment in the various sectors is not complete. In my view, more adjustments will take place in the manufacturing sector, which means that there will also be further adjustments in other sectors, especially those where demand is very high, such as the natural resources sector and the residential construction sector. So, adjustments between various sectors will continue.

[Paule Brunelle, Bloc, Trois-Rivières, QC]

So you are saying there could be more job losses. We just do not know.

In your presentation, you said that the Canadian economy is still going to grow. There is talk of a recession in the United States.

According to your presentation, this will not happen in Canada. Is my understanding correct?

[Paul Jenkins]

According to our base scenario, there is no recession in the States. As John mentioned, in the first semester of this year, there will be very slow growth, at an annualized rate of close to 0.5 percent, but not a recession. This growth rate will have an effect on the Canadian economy.

As I mentioned in my presentation, the Canadian economy is projected to grow in the first semester, but in our base scenario there is no American recession.

[Paule Brunelle, Bloc, Trois-Rivières, QC]

Many experts have announced this recession in the United States. Is your projection due to the recent statements of President Bush who tried to reassure the markets.

[Paul Jenkins]

It is difficult to comment on other countries' policies. According to our base scenario, the turnaround in the US economy in the second semester of this year will come as a result of US monetary policy. There are also tax incentives that will contribute to this turnaround.

[Paule Brunelle, Bloc, Trois-Rivières, QC]

Do I have some time left?

[The Chair, Conservative, James Rajotte]

You have two minutes left.

[Paule Brunelle, Bloc, Trois-Rivières, QC]

I would like to raise another subject. In your presentation, you mentioned that due to the volatility of the dollar, people have called for the Canadian dollar to be pegged to the US dollar, but that this would be a mistake. Have you considered a common currency? It seems to me that this has been a success in Europe, with the euro. Is a common currency for the Americas, or at least for North America, still being seriously considered?

[Paul Jenkins]

This is a vast subject. I would like to emphasize that the structure of the US economy is very different from that of the Canadian economy. For example, a shock on commodity prices, on natural resource prices, is a positive shock for Canada and an improvement in our terms of trade, but for the US economy, it is a negative shock.

It was the same thing after the Asian crisis: the impacts on our two countries were different. It is therefore important to be able to manage our economy according to the shocks felt, which are different. A fixed exchange rate within a common currency would mean that Canada's monetary policy would have to be the same as America's monetary policy. That is a fact.

[The Chair, Conservative, James Rajotte]

Thank you.