Mr. Mark Carney (Adviser to the Governor, Bank of Canada):
Thank you very much, Chair, and I do look forward to discussion of substantive issues.
I would like to begin by saying how pleased I am to be before this committee today to discuss my perspectives on the medium-term policy challenges facing the Bank of Canada. I am looking forward to many future appearances before this committee and its counterpart in the Senate, since a critical component of the bank's accountability to Canadians is having the governor appear periodically before parliamentarians to explain the bank's views on the economy, monetary policy, and the financial system.
I would like, however, to emphasize at the outset that I am not yet the governor of the Bank of Canada. Under the Bank of Canada Act, the current governor, David Dodge, remains very much responsible for Canada's monetary policy until the end of January. In recent years, the bank has operated under a convention whereby monetary policy decisions are taken on a consensus basis by the bank's governing council. I am also not yet a member of the governing council. In answering your questions today, I shall endeavour to comment neither on the current stance of monetary policy nor on the current economic outlook, so as to avoid prejudicing upcoming decisions of the governing council. I trust that all those listening will recognize those important caveats.
Reflecting my current position, I would like to focus on the principal medium-term policy challenges facing the bank. As set out in the preamble to the Bank of Canada Act, the bank's objective is “generally to promote the economic and financial welfare of Canada”. The bank achieves this objective by, first, conducting monetary policy to maintain a rate of inflation that is low, stable, and predictable; second, promoting the safety and soundness of Canada's financial system; third, acting as the Government of Canada's fiscal agent to provide efficient and effective funds management; and, fourth, supplying quality bank notes that are readily accepted and secure against counterfeiting. This last point, if I may, is very important to the bank, and we have worked closely with our partners in law enforcement, particularly the RCMP, and the retail sector to deter counterfeiting through bank-note-related education, communication, and compliance. These efforts have yielded important results, and they will continue.
With that introduction, I will concentrate the balance of my remarks on the bank's work in monetary policy and the financial system.
With respect to monetary policy, I am in the fortunate position of inheriting an exceptionally sound and robust policy framework. Over time, it has become clear that the best contribution monetary policy can make to the promotion of the economic and financial welfare of Canada is to keep inflation low, stable and predictable. Put another way, inflation control is not an end in itself; rather, it is the means whereby monetary policy can best contribute to solid economic performance. Specifically, the Bank aims to keep the annual rate of consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent control range. By doing so, monetary policy helps to keep the economy as a whole operating at full capacity and promotes sustainable economic growth.
Canada has been served extremely well by its inflation-targeting policy framework, which has been widely emulated. The Bank's exemplary record of inflation control has meant that we have avoided the destructive effects of high inflation prevalent in earlier decades—effects that were disproportionately felt by poor Canadians, and which reduced our output and increased our unemployment. Despite all the shocks that Canada has faced since inflation targets were introduced, Canada's real output since that time has expanded at an average rate of 3 per cent per year and the unemployment rate has fallen to levels not seen in more than three decades. As in countries where inflation targeting has been adopted, inflation and interest rates have generally been lower and less volatile.
An explicit inflation target was first formalized in a joint agreement between the Bank and the Government of Canada in 1991. Given its initial success, this agreement has been extended four times with small modifications; most recently, until the end of 2011. This agreement sets out one clear objective—the inflation target—and creates a transparent accountability framework for the Bank of Canada. The Bank supports that framework through frequent and open communication with Canadians. If inflation deviates from its target, the Bank will explain the reasons why, what it will do to return it to target, and how long the process is expected to take. It is important to underline that the Bank approaches inflation control in a symmetric way.
A floating exchange rate is a key element of our monetary policy framework. It allows Canada to pursue an independent monetary policy appropriate to our own economic circumstances. Although there is no target exchange rate for the Canadian dollar, the bank does care why the exchange rate is moving and what the potential impact will be on output and inflation.
The exchange rate is an important relative price in our economy. Movements in the exchange rate influence the levels of imports and exports, which can help keep total demand and supply in balance. Further, exchange rate movements act as a signal to shift resources into sectors where demand is strongest. A floating exchange rate helps to smooth that process and to minimize the adjustments in other areas of the economy.
The challenge for the bank is to understand the reasons behind currency movements, to incorporate those with our assessments of other data, and to set a course for monetary policy that works to keep total demand and supply in balance and inflation on target. This means that the bank has to make judgments about the causes and likely persistence of exchange rate movements, the speed and degree at which exchange rate changes pass through to domestic prices, and the possible impact of exchange rate movements on confidence, and through confidence, on consumption and investment.
It is true that exchange rate movements can be, and have been recently, rather volatile. In these circumstances, it is not surprising that some have called for Canada to fix its currency to the U.S. dollar. In my opinion, it would be a mistake to do so. It would mean that, de facto, Canada would adopt U.S. monetary policy despite the reality that the structures of our economy are very different and, as a consequence, often require different types of adjustments in response to global developments.
We cannot avoid adjustment. The question is simply how we adjust to global 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 these adjustments are more protracted and more difficult than exchange rate adjustments. Again, however, I stress that this position does not mean the bank is indifferent to movements in the exchange rate.
Another important aspect of our policy framework is the need to be forward looking given the lags between policy actions and their effect on the economy. Indeed, a forward-looking perspective is essential to the success of inflation targeting. The joint agreement between the Government of Canada and the Bank of Canada on the inflation target has helped concentrate inflation expectations at around 2%.
More fundamentally, the successful management of monetary policy by my predecessors has created a self-reinforcing process whereby increased policy credibility further anchors inflation expectations, which then contributes to a more stable macroeconomic environment, which in turn enhances policy credibility. We should not underestimate the value of these hard-won gains, and I have no intention of forfeiting them.
Well-anchored inflation expectations help reduce swings in interest rates, lower the cost of borrowing to Canadians, contribute to a more stable, competitive cost of capital for our firms, and ultimately support more sustainable growth in output and employment.
Now, despite our successes, the bank has an obligation to Canadians to continually evaluate possible improvements to its policy framework. As a result, the bank has launched a concerted research program to examine whether and how the monetary policy framework in Canada might be improved. This program is focusing on the potential costs and benefits of targeting a lower rate of inflation and of pursuing a price-level target instead of an inflation target. And it is focusing on the challenges of communicating these potential changes to Canadians.
The bank will conduct this research and publish its findings in an open manner in order to encourage debate and suggestions. I will say that the research would need to uncover compelling evidence in favour of a change before we would want to alter a system that has proven so successful over the past 15 years.
The conduct of monetary policy over the coming years will be challenged by four underlying trends. Their precise speed is difficult to predict, but their influence will be impossible to ignore. These trends are as follows:
First is the globalization of product capital and, increasingly, given outsourcing and technology, labour markets.
Second is the resolution of global imbalances. This requires both stronger domestic demand in countries with large current account surpluses and the move to flexible exchange rate regimes in those systemically important countries that currently actively manage their exchange rates. As the bank has consistently noted, this process may proceed in an uneven manner.
Third is the pace and direction of financial innovation and integration. This has important implications for the degree of financial intermediation, the levels of nominal and real interest rates, and the monetary policy transmission mechanism.
Fourth is the evolution of potential growth in Canada reflecting the balance of profound demographic changes in developments in Canadian productivity.
These underlined economic and financial trends complicate the pursuit of our inflation target, not only because none is likely to proceed at a steady, predictable pace, but also because they are all interrelated. For example, global imbalances, financial integration, and historically low nominal interest rates can all be partially explained by the familiar process of global integration that is currently taking place on an unprecedented scale.
The bank must better understand these forces to effectively meet its responsibilities. It should also continue to share its perspectives on these broader trends so that individual Canadians, companies, and governments have the necessary context when making their savings and investment decisions.
The strength of our financial system will help determine the ultimate impact of these trends, since each has the potential to affect asset-price volatility and the stability of growth and employment. Where financial systems are strong and resilient, they cushion shocks, efficiently allocate resources, and help improve the effectiveness of monetary policy. Where they are weak, however, they can amplify the impact of shocks on macroeconomic activity and reduce the effectiveness of monetary policy. As a consequence, the Bank has a fundamental role to play in promoting the safety and stability of Canada's financial system.
The Bank's role in financial stability is at the heart of our legislated mandate to promote the economic and financial welfare of Canada. Before concluding, I would like to make five brief comments in that regard.
First, as Canada's central bank, we have legislative oversight responsibility for the safety and soundness of systemically important clearing and settlement systems.
Second, we play a central role in providing liquidity to facilitate the settlement of financial transactions. The Bank has traditionally undertaken open-market by-back operations only in Government of Canada debt, and offered standing liquidity facilities against high-quality collateral, in order to keep the overnight rate close to the target policy rate. However, recent events have raised questions over the appropriate role for central banks in the provision of liquidity in money markets. As my colleague, Pierre Duguay, noted last month, the Bank is currently examining whether some market failures might be addressed if the central bank had a facility that would provide liquidity at terms longer than overnight, possibly secured with a wider range of securities.
Third, the response to the recent turbulence in financial markets should reaffirm that market participants are fundamentally responsible for their actions. For example, investors must understand the price dynamics and liquidity risks of the products they buy, rather than relying solely on credit-rating agencies. The market is beginning to lead many of the necessary changes, as institutions are improving their liquidity management and credit discipline and as originators and distributors of new loans are beginning to adjust their products to standardize terms and, importantly, align incentives. At the same time, accurate and timely information about underlying risks is essential for the market to differentiate and properly price risk. Thus, as Governor Dodge highlighted in September, enhanced disclosure and transparency remain crucial.
Fourth, recent global events have underscored the importance of continued close cooperation among authorities in Canada. The bank will continue to work collaboratively with its partners, including the Department of Finance, OSFI, the Canada Deposit Insurance Corporation, and provincial securities commissions, to promote the safe and efficient operation of the key elements of our financial system.
Finally, the bank will continue to use its membership in international bodies and its extensive research capabilities to foster the safety, soundness, and efficiency of the international financial system. For example, the bank and the Government of Canada have actively promoted reform of the International Monetary Fund through a strengthened surveillance function. Strengthened surveillance can play an important role in the resolution of global imbalances and the development of a more robust international financial system. As part of the international response to recent market turbulence, the bank is also working through the Financial Stability Forum as that body considers possible changes to accounting and regulatory standards and the extent to which enhanced oversight can improve the management of credit and liquidity risk in global financial institutions.
In conclusion, let me say that it is an honour and a privilege to have been chosen to serve Canadians as the eighth Governor of the Bank of Canada. I am particularly looking forward to leading the bank's talented and dedicated staff as we face the challenges of the years ahead. I will do my best to live up to the very high standards of those who came before me and am confident that my experience in both the public and private sectors will help me contribute to the bank's important work on behalf of all Canadians.
Thank you very much for your time, and I look forward to your questions.
Mr. Mark Carney:
Thank you very much for the question. It's extremely important, and obviously extremely timely.
Certainly, we have seen substantial volatility in exchange rate markets recently, including that for the Canadian dollar. It's important to remember, as you know, that exchange rate markets, like all asset markets, can be volatile and can overshoot, and certainly the volatility we have seen in the Canadian dollar cannot be accounted for purely by changes in fundamentals.
We can discuss, if you wish--although you may not want to use the time--potential reasons behind that volatility, but I'll leave that to the side and go more to the substance of the question, which is what the bank can do.
I'll say, first and foremost, because it bears repeating, that the experience of the bank, the experience of Canadian monetary history, is that the best contribution the bank can make to the economic and financial welfare of the country is to focus on its principal and sole objective, which is to achieve an inflation rate that's slow, stable, and predictable.
In the context of doing that, as I mentioned in my remarks, the exchange rate does play an important role, and certainly exchange rate movements that are detached or somewhat differentiated from fundamental movements need to be considered in the conduct of monetary policy.
How do we consider them? We need to look at the reasons the exchange rate may have moved; we need to think through the persistence of those exchange rate changes. We've obviously seen a very sharp spike up and rapid return. Then we need to think about the consequences of this for the economy, all in the context of achieving the exchange rate target.
What specifically can the bank do? I do not favour a pegged exchange rate. I do not favour a monetary union. We can go into more detail on why, if people wish to later. But I think there is a premium on the bank communicating openly with Canadians, being open with the market about the potential impact of these changes on output and, ultimately on inflation, and providing a sense of stability as its objective function.
The way to inject more volatility into asset markets, whether they're interest rates, exchange rates, or equities, is to be perceived to change between targets. I would submit that at the bank we need to retain focus on the inflation target, explain what we're doing, explain what the potential consequences are of exchange rate movement, differentiate between the potential reasons behind that, and the market will adjust accordingly.
Mr. Mark Carney:
Thank you for the question. I do want to leave this as one of the messages in my remarks, but these issues are very topical and very important, and I think they will extend well into the first year, certainly, and potentially beyond the work program of my tenure at the Bank of Canada. So it's not only a current topical issue; these are deeper issues.
I'll reiterate that there is a very fundamental role for the bank in financial stability. Financial stability and monetary policy are very tightly linked.
The first thing we do is to make sure we provide liquidity. We set an overnight target rate. It was changed yesterday, as you all know, and we want the actual rate in overnight money markets to be the overnight target rate. So we provide--it seems sensible--liquidity into the overnight market occasionally, as required, in order to ensure that on average the overnight rate is the target rate. We have done that recently, and we have done it frequently, I guess, since August. It's common to other central banks around the world during this time of some stress in the money markets.
The issue is, what happens between the overnight rate and the rates about three months out? What you have in Canada is a fairly steep, unusually steep, yield curve going from overnight to three months out, and three-month rates are important rates for financial institutions.
The curves in the U.S., in Europe, and in the U.K. are much steeper than they are in Canada. So if we have an issue, it's a bigger issue elsewhere. And the question is--and this is what I was referring to in terms of instruments--what can the bank do or what should the bank potentially do to ensure that there is necessary liquidity further out so that changes in the overnight rate are transmitted out along the curve?
I will make one side point, if I may--it is simply an observation--which is that the change in the overnight rate yesterday has resulted in a lowering of that curve. So while the curve is still steep, at least it is moving with the overnight rate.
That's some of the aspect of what we're looking at in terms of providing some term liquidity. It is a very topical issue. It's being discussed, and you will see it consistently south of the border and in Europe, where they quite frankly have more flexibility in that overnight to three-month area than we currently do at the bank.
The other things we need to do, very quickly.... I think we need to consistently monitor the situation, both from a macroeconomic perspective and to bring it on down to individual institutions, and that's where we work with OSFI, the Department of Finance, and CDIC to make sure everybody has a best sense of the situation. I should reiterate for the committee that the bank is the lender of last resort, if necessary, to federally regulated institutions, solvent but illiquid federally regulated institutions, and we are actively working internationally through the Financial Stability Forum to provide our input to broader reforms.
A last point, though, and I don't want to leave any doubt, is that there is a fundamental principle here that what we're trying to do is make sure that current issues in the financial system do not propagate into the broader economy and impact the broader economy. But there is a principle that market participants should bear the consequences of their actions, so we need to strike the right balance between those two very important principles.
Mr. Mark Carney:
Thank you for that.
One of the problems with success is that you forget why you put in place the framework to begin with.
As I said in my remarks, we've had 15 years of low, stable, and predictable inflation. We owe it to my predecessors and the excellent and dedicated staff at the bank for achieving that success, but we have had 15 years, and people do forget about the costs of inflation. The cost of inflation, I want to emphasize, is what we risk putting in peril if we take our eye off the ball, and I want to assure you I will not take my eye off the ball.
Inflation erodes the value of money. I will put an aphorism in, a Yogi Berra: a nickel ain't worth a dime any more. That is the reality. We see the debate about what to do with a penny; ultimately, that's the consequence of years of inflation compounded.
Second, inflation creates uncertainty. It creates uncertainty and has a marked impact on investment and consumption, but investment ultimately, and output and jobs.
Third--and I mentioned this in my remarks, but it really does bear repeating--inflation affects the most vulnerable. It's the poorest people in society who are least well positioned to hedge against inflation and least well positioned to use sophisticated financial products or contracts to protect themselves.
The fifth and most important point when we think about inflation--I shouldn't say the most important point, but the fifth point--and one that really does bear emphasizing, is that inflationary booms always end badly, and you often get a boom when you start to have a run-up on inflation. They always end badly, and Herculean effort is required to put us back onto the path we were already on.
Right now we have low, stable, predictable inflation. We have expectations well anchored. It's incredibly valuable. To those who think about changing the target or adding additional targets when we only have one instrument, I would point out the risks they run in terms of impacting all these costs.
Mr. Mark Carney:
In terms of the first part of the question, when I was overseas with an investment banking firm, my work was principally with sovereign governments, particularly emerging markets as they really emerged. For example, there was South Africa, when the ANC came to power and they were doing their first financings, Korea, and other nations like that. I didn't really touch on Canada until I came back to Canada. So the short answer is no, I did not hear about that issue.
The broader issue, though--which is an important one and one close to the heart of the Bank of Canada--is how we enhance the competitiveness and efficiency of our capital markets.
There are things we can definitely do, and I'll start with what the bank can do. It starts with making sure we have an efficient fixed-income market, starting in money markets.
We talked a bit about the potential facility and what that role would be, but we must make sure we conduct our core oversight responsibilities for the payment system. That's important for the money market. We act as agent for the government in federal government debt. The consolidation of government debt, of some of the crowns into government debt, has been a success. We need to get the right level of liquidity there.
I think we need--and this is beyond our responsibility because the market has to do this--securitization to continue in this market. Securitization is under real pressure, and rightly so, because some products have become too complex, but it should shrink down to a core of more standardized products, which can really enhance the efficiency of markets.
We have to strengthen market integrity. Governance is an aspect, but better enforcement is absolutely crucial. I'd recommend the report of Nick Le Pan on IMETs and the role of the RCMP. But an important aspect here is that this is a shared responsibility. So it's not just the RCMP; it's provincial, it's crown prosecutors, it's provincial securities commissions. We'll do what we can to help.
I'd like to make my last three points.
One is about value, openness, and competition. The foreign property rule was removed in 2005. That opened up a lot of exciting markets for our investors abroad. That's important for our retirements. But it also created markets, such as the Maple bond market in Canada. This idea of having the Toronto Stock Exchange push free trade and securities is again the type of thing that can improve competition in Canada. We'll get better results if we have more competition. That's the basic point.
On regulation, my personal view is that I see a value to proportionate regulation, respecting different sizes of companies, different requirements for different sizes of companies, principle-based regulation. And I'll say one lesson to take from what happened in the summer is that people will come up with fancy new financial products. They will be very complex. The next turmoil--to use the official term for what happened--won't look like the last one. There will be different products. If you have principles, you can guide the conduct of those products, but if you have rules, people will get around them. And that's the experience of the market.
Last is investor education, but it's five o'clock and I won't be able to get into that.