FINA Committee Meeting

37th PARLIAMENT, 1st SESSION

Standing Committee on Finance

EVIDENCE

CONTENTS

Wednesday, April 24, 2002

¹

1530

The Chair (Mrs. Sue Barnes (London West, Lib.))

Mr. David A. Dodge (Governor, Bank of Canada)

¹

1535

The Chair

Mr. Charlie Penson (Peace River, Canadian Alliance)

¹

1540

Mr. David Dodge

¹

1545

Mr. Charlie Penson

Mr. David Dodge

Mr. Paul Jenkins (Deputy Governor, Bank of Canada)

Mr. Charlie Penson

Mr. Paul Jenkins

¹

1550

The Chair

Mr. Malcolm Knight (Senior Deputy Governor, Bank of Canada)

The Chair

Mr. Richard Marceau (Charlesbourg--Jacques-Cartier, BQ)

M. David Dodge

Mr. Richard Marceau

¹

1555

Mr. David Dodge

Mr. Richard Marceau

º

1600

Mr. David Dodge

Mr. Richard Marceau

Mr. David Dodge

The Chair

Mr. Bryon Wilfert (Oak Ridges, Lib.)

º

1605

Mr. David Dodge

º

1610

The Chair

Mr. Malcolm Knight

The Chair

Mr. Bryon Wilfert

The Chair

Mr. Lorne Nystrom (Regina--Qu'Appelle, NDP)

º

1615

Mr. David Dodge

º

1620

Mr. Lorne Nystrom

Mr. David Dodge

º

1625

The Chair

Mr. Nick Discepola (Vaudreuil--Soulanges, Lib.)

º

1630

Mr. David Dodge

Mr. Malcolm Knight

º

1635

The Chair

Mr. Scott Brison (Kings--Hants, PC)

º

1640

Mr. David Dodge

Mr. Scott Brison

Mr. David Dodge

º

1645

Mr. Scott Brison

Mr. David Dodge

Mr. Malcolm Knight

Mr. Scott Brison

Mr. David Dodge

º

1650

Mr. Paul Jenkins

The Chair

Ms. Maria Minna (Beaches--East York, Lib.)

The Chair

Mr. David Dodge

º

1655

»

1700

The Chair

Mr. David Dodge

Mr. Paul Jenkins

The Chair

Mr. Grant McNally (Dewdney--Alouette, Canadian Alliance)

»

1705

Mr. David Dodge

The Chair

Ms. Sophia Leung (Vancouver Kingsway, Lib.)

»

1710

Mr. David Dodge

»

1715

The Chair

Mr. Richard Marceau

Mr. David Dodge

Mr. Malcolm Knight

Mr. David Dodge

»

1720

The Chair

Mr. Nick Discepola

»

1725

Mr. David Dodge

»

1730

The Chair

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CANADA

Standing Committee on Finance

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NUMBER 093

l

1st SESSION

l

37th PARLIAMENT

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EVIDENCE

Wednesday, April 24, 2002

[Recorded by Electronic Apparatus]

¹  (1530)  

[English]

    The Chair (Mrs. Sue Barnes (London West, Lib.)): Welcome, everyone. This is the Standing Committee on Finance. The order of the day, pursuant to Standing Order 108(2), is consideration of the Bank of Canada's “Monetary Policy Report”, April 2002.

    We are very pleased to have with us from the Bank of Canada, David Dodge, the governor; Malcolm Knight, the senior deputy governor; and Paul Jenkins, the deputy governor.

    Thank you very much, gentlemen, for joining us today. We're anxious to hear your comments on your report. Whenever you are ready, please commence.

    Mr. David A. Dodge (Governor, Bank of Canada): Thank you, Madam Chair. It's a great pleasure for the three of us to be here today, especially on a day when the sun is shining outside.

    When Malcolm and I appeared before you last November, there really was a heavy cloud of uncertainty hanging over the outlook for the world economy and for Canada. Much of that uncertainty stemmed from the September terrorist acts in the United States, which had come at a time when the global economy had slowed more than expected. To counter that uncertainty and to bolster consumer and business confidence, the bank moved aggressively to provide monetary stimulus. Between September and January 2002, we lowered interest rates by 200 basis points, bringing the total since January 2001 to 375 points.

[Translation]

    As it turned out, consumer confidence was not as badly shaken in the aftermath of those tragic events as had been widely feared. Indeed, confidence bounced back as perceived geopolitical and economic uncertainties diminished. The world economy has begun to strengthen. Here in Canada, a robust recovery appears to be underway. Growth in the fourth quarter of last year and the first quarter of 2002 was appreciably stronger than expected, so that the level of economic activity is now higher than we thought it would be six months ago. This momentum is reflected in the extraordinary number of new jobs created since the beginning of 2002. In terms of the two scenarios we painted last November, clearly, we are into the more optimistic one, in which a recovery in consumer confidence leads to an early resumption of economic growth.

[English]

    What do we see when we look ahead? The bank projects that in the first half of 2002, the Canadian economy will grow by between 3.5% and 4.5% at annual rates. We expect that it will continue to expand in the second half of this year and in 2003 at a rate somewhat above the production capacity or potential, which we estimate to be around 3% a year. This means our economy should return to full capacity in the second half of 2003.

    The output path I've just sketched is consistent with core CPI inflation being at 2% by about the end of next year. Total CPI inflation will probably continue to fluctuate in the coming months as oil and natural gas prices move around. But like core inflation, we expect it to be about 2% by the end of 2003.

[Translation]

    Although we no longer face the same degree of uncertainty as we did last fall, there are still important risks and uncertainties in the outlook, some of which are working on the upside and others on the downside.

    Given the amounts of monetary and fiscal stimulus in the economy, output growth could be even stronger than projected. However, it is also possible that some of the recent strength in spending on consumer durables was borrowed from the future, so that the growth of household expenditures will be weaker than expected. At the same time, there is still considerable uncertainty about the timing and strength of the pickup in business investment in North America, mainly because of the continued weakness in profits. Moreover, tensions in the Middle East could have implications for crude oil prices and the global economy.

[English]

    But what do recent developments in Canada mean from a policy perspective? With our economy now operating at a significantly higher level than we had expected, the amount of spare capacity is smaller and is now projected to be absorbed sooner than we thought last November. In these circumstances, our job at the bank will be to gauge the strength of the economy as it approaches capacity to produce, and to reduce the amount of monetary stimulus in place in a timely and measured manner. We want to ensure that inflation stays close to the target so that over the medium term our economy can continue to grow at full capacity.

[Translation]

    Over the past year, we put the “pedal to the metal” to help us get up the hill of economic difficulties. The prudent thing now, as we return to more normal driving conditions, is to ease off on the gas pedal - ease off, not slam on the brakes - to make sure that we continue our journey along the highway at a safe cruising speed.

[English]

    Over the past year we at the bank put the pedal to the metal, so to speak, to help us get up the hill of economic difficulties. The prudent thing now, as we return to more normal driving conditions, is to ease off a bit on the gas pedal, not slam on the brakes, to make sure we continue our journey along the highway at a safe cruising speed. It's in line with this: that we moved on April 16 to raise the target for the overnight interest rate by 25 points.

    Madame Chair, Malcolm, Paul and I are now ready to respond to your questions.

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    The Chair: Thank you very much.

    We'll commence with Mr. Penson, please, for ten minutes.

    Mr. Charlie Penson (Peace River, Canadian Alliance): Thank you very much, Madam Chair.

    I'd like to welcome you, Mr. Dodge, and your officials here today.

    What a difference a year makes, Governor, with a significant turnaround in the Canadian and American economies, as we've seen, and a growth period for Canada again.

    I have three questions I would like to ask you. The first has to do with interest rates, the rise in interest rates, how far we want to be moving above the U.S. in terms of levels, what kind of spread would we be prepared to maintain if they don't move or if they move at a different rate than we do.

    Secondly, I see you also provide advice to the Government of Canada on management of the public debt, and I wonder what advice you're offering to Mr. Martin and Mr. Chrétien these days in terms of paying down debt versus spending or tax reduction. Could you give us a brief glimpse of that?

    Also, if you have time, I would like you to address the transparency issue in international banks, particularly the Japanese banks, the difficulty they're having and how the issue of transparency is being resolved so that people who are investing would have a better chance to see what the real picture is in the banking community in Japan.

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    Mr. David Dodge: Thanks very much. With respect to the first question, we in Canada, like central banks elsewhere in the world, have to conduct our policy in light of our own economic conditions. That's why you'll see central banks operate differently at different times around the world. Just as Mr. Greenspan has to conduct his policy appropriately for the U.S. economic conditions, we have to conduct ours appropriately for ours.

    There are a couple of differences at the moment. First off, the Canadian slowdown was not as deep as that in the United States, and the rebound has been much sharper here, especially the rebound in final sales. Hence it's fair to say that we are operating now closer to production potential not only than we had imagined when we were sitting around this table last fall but closer than the Americans are operating currently. Thus, given our desire to try to operate monetary policy such that we work at capacity as much as possible, it is quite appropriate for us to be following a policy that reduces perhaps a little bit more quickly the amount of monetary stimulus in the system than for the Americans, just as it has been appropriate, say, in the United Kingdom for the Bank of England to put perhaps a little bit less monetary stimulus into their system because the slowdown in the U.K. relative to their potential was not as great as it was here in North America.

    So the first point is that we follow policies that are appropriate for Canada and the Americans follow policies appropriate for the U.S.

    Let me turn to your second question, and then I'm going to ask Paul Jenkins, who is the deputy governor in charge of the international side, to address your third question.

    Our job in managing the public debt really has to do much more with the structure of the debt and managing it in such a way that we minimize the debt charges that Canadian taxpayers have to bear, subject to appropriate prudence so that we don't cram it all at the very short end so that there are risks of rollover, and so on. That is our job as manager of the debt. Obviously it is terribly important for governments in Canada, not just the federal government but provincial governments as well, that over the course of this decade, when our labour force participation is at its peak, we as much as possible take steps to pay down a bit of that debt and certainly to reduce the ratio of public debt to GDP.

    But it is not the bank's job to advise on that, except that my views on this are obviously well known, and to the extent that we can reduce the burden of public debt, that means either taxes can be lowered or more of taxpayers' money can go to provide the real goods and services that governments are called on to provide.

    Secondly, and very importantly, it gives monetary policy a little bit more scope to operate so we can cope with the ups and downs in the business cycle a little bit better.

¹  (1545)  

    Mr. Charlie Penson: I have a question, then, about the term of the debt, how you manage that, what your outlook is--shortened terms for holding of the debt or lengthening terms? Where are you going with that issue?

    Mr. David Dodge: As you know, during the course of the early part of the 1980s and well into the late part of the 1980s, the Government of Canada had to do a lot of borrowing, and because interest rates were very high, we borrowed most of that short. So by the time we got through the very bad downturn in 1991- 92, we found ourselves really quite exposed with a lot of short-term debt and very little long-term debt. We began, at that point, to lengthen the term out, and we moved from roughly a 50-50 mix of short and long to about the 70-30 mix.

    Now that we have inflation well under control and long rates have come down without a great inflation premium in them, and the ratio of debt to GDP has come down, obviously we have more flexibility than we had back then. While we won't move nearly as rapidly, and shouldn't move nearly as rapidly, to vary the structure of the debt as we did back then, there perhaps is some room now, especially because the ratio of debt to GDP has been reduced and will continue to be reduced. There is perhaps a little bit more opportunity to reduce the cost to the taxpayer by shortening up a little bit. But I emphasize that's at the margin, because as a country, we still have relatively more floating debt than many other countries.

    Maybe I could turn to Mr. Jenkins now to answer your third question.

    Mr. Paul Jenkins (Deputy Governor, Bank of Canada): Thank you, Governor.

    With regard to the issue of transparency and the Japanese bank, I think there is, in a sense, a broader issue here that relates to transparency more generally. What I'm thinking of in particular is that immediately after the Asian crisis, and shortly following it, the problems in Russia and Latin America, there was a considerable effort on the part of the international community to address this exact issue of a need for increased transparency, in this case, with regard to the international financial system. I think a considerable amount of progress has been made on that front. You see evidence of that I think in a number of different areas. I'm thinking here in particular of the way markets are better differentiating across credit quality in the emerging markets, and that was the initial focus of this effort. There's more information being made available in a much more constructive manner

    But in addition to these efforts being applied to emerging markets, they're also being applied to developed markets, and I'm thinking here in particular of a program that has been instituted by the International Monetary Fund where they go into countries and review the full gambit of their financial system. In fact, Canada was one of the first countries that the International Monetary Fund came into, almost as a pilot project--one of the first two countries they looked at. That same program is now being applied to Japan for the reasons you're suggesting.

    So there's a considerable amount of effort internationally, in the context of the international monetary system, financial system, generally, but it's also being applied in the case of Japan. So there is considerably more information being provided to increase transparency to give savers and investors more information to be able to make the sorts of judgments and investments you're referring to.

    Mr. Charlie Penson: There's more leverage when a country needs IMF funds to restructure, hence the question about Japan. I understand the Argentine situation because they need IMF money, but what about Japan?

    Mr. Paul Jenkins: The point I'm getting at is that in the context of Japan there are clear efforts under way to provide more information. There is also an internal agency that has been set up, which has just provided additional updates in terms of the situation of their financial system.

    The markets themselves are getting access to more information. Starting last month, the financial institutions in Japan are now marking to market, adapting international accounting standards.

    So in terms of what is being provided, what is being done from a transparency point of view, I think a considerable amount is under way. It's not yet ideal, we're not exactly where we wish to be, but I think if you look back three or four years, and look at the situation today, there has been considerable progress made, but it's being applied to the developed markets as well as to the emerging markets.

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    The Chair: We are out of time, but I'm going to allow Mr. Knight... I think you were going to add a comment.

    Mr. Malcolm Knight (Senior Deputy Governor, Bank of Canada): I'll just very briefly add to what Mr. Jenkins said. After the Asian crisis in 1997-98, the banking supervisors of the Group of Ten, the so-called Basel Committee, did develop a set of principles for effective banking supervision that are being used to try to increase transparency in the banking systems of all the fund member countries. It's in the context of those principles that the IMF has been reviewing financial systems in Canada and in many countries of the world. We were fortunate in that we proved to have a very strong, stable financial system, but I do believe that despite these steps that have been taken, the issues of transparency and international financial institutions are generally major ones.

    The Chair: Mr. Marceau, you have ten minutes

[Translation]

    Mr. Richard Marceau (Charlesbourg--Jacques-Cartier, BQ): Thank you, Madam Chair.

    Governor Dodge, Deputy Governors, thank you for being here today.

    Governor Dodge, not that long ago, you seemed more receptive than your predecessor to the idea of an eventual monetary union with the United States. Could you tell us why that is?

    M. David Dodge: It's not easy to compare me with my predecessor. Nevertheless, I did state that the current system was and would continue to be for the foreseeable future, more beneficial for the Canadian economy. This is an empirical, rather than a philosophical position. Given that the surplus in the Canadian economy is substantially different from that of the United States, the prices of our products vis-à-vis those of US products fluctuate constantly. It's much easier to adjust to these changes with a floating exchange rate.

    However, it is possible that at some point down the road, structures will become more similar and a more substantial integration of markets, including the labour market, will occur. If that happens, then it will be important to reassess the situation.

    Mr. Richard Marceau: In the event this scenario becomes a reality, shouldn't the country's elected representatives take it upon themselves to move immediately to closely examine the different monetary regimes that could apply in Canada? For example, a decision could be made to maintain either a floating or a fixed exchange rate, to form a monetary board or to set up a monetary union. When you tell us, in your capacity of Governor of the Bank of Canada, that this reality could come to pass, are you also telling us that we should be taking steps right now to examine the various options open to us?

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    Mr. David Dodge: Yes. These are issues that the Bank ponders on an ongoing basis. Virtually every quarter, the Bank of Canada Review contains an article on our research efforts in this area, albeit from a monetary perspective. It's equally, if not more important to look at ways of integrating markets and the effects of this process. As a rule, when we talk about integration in the context of two or more countries, we start with the integration of a single market, whether it be the goods and services, capital or labour markets. Although the US and Canadian capital markets are already fairly well integrated, a number of problems still persist, as you well know, in the goods and services market. Moreover, there is no labour market integration whatsoever. The question of a monetary union will naturally follow the integration of other markets. And even if the integration of the other three markets becomes a reality, if major structural differences in the respective economies remain, it may well be preferable to have a floating exchange rate to allow for more efficient adjustments to economic cycles.

    Mr. Richard Marceau: Regarding structural differences in the economies, it's no secret that this government's official policy is to establish a Free Trade Area with the Americas by 2005. Some pundits and even some governments policy sectors have suggested that there is a monetary component to the FTAA under the guise of the Monetary Institute of the Americas. This institute would be patterned on the European model, that is not on the European Central Bank, but on the European Monetary Institute which oversaw the transition from different national currencies to a single currency, specifically the Euro.

    In your opinion, would it be a good idea to establish an international institute to decide on admission criteria for different countries in to a common monetary zone? For instance, to follow up with your analogy, we could start with the United States and Canada, if ever the Canadian and US economies became sufficiently integrated to allow for the formation of a monetary zone which could then be expanded to include Mexico and other countries.

    The Mexican government, speaking through its Ministry of Foreign Affairs and Business Council, has already publicly endorsed the creation of an institute such as this. In your opinion, does this idea warrant further consideration and the endorsement of Parliament for implementation, in not immediately, then at least in the foreseeable future?

º  (1600)  

    Mr. David Dodge: Naturally, that's up to the government, not us, to decide. The European Institute was established in the wake of the Maastricht Treaty, which formed the basis for a single market. Problems continue, among other things, with the integration of all national rules, but great strides have nevertheless been made as a result of the creation of a single market. The consensus at the time was that ultimately, the natural thing would be to consider a monetary union within a single market of 12 countries.Most likely, 15 countries will eventually participate, but for the moment there are 12 countries. An institute was therefore established to pave the way for this union.

    We haven't quite reached this stage here in North America. With our free trade agreement, we're probably at the stage Europe was at in the 1950s and 1960s.

    Mr. Richard Marceau: How do you respond to those who would advance the following argument? In Europe, a country exports on average 63 per cent of its products to another European country, whereas in Canada, as everyone well, knows, between 85 per cent and 87 per cent of Canadian exports are destined for a single market, namely the United States. Would you not agree that North American economic integration is already further along that European economic integration was at the time the Euro was adopted, namely three years ago already?

    Mr. David Dodge: There are considerable differences between Canada and the United States. In Europe, for example, the economies of France and Germany are similar in terms of their structure. The same cannot be said of the Canadian and US economies. One never knows. Perhaps down the road, the two economies will become more integrated, but the opposite could occur as well. The situation here in North America is so different that we cannot pattern ourselves on the European model. Mind you, I'm talking about economic situations. I'll leave the discussion of the political situations to you.

[English]

    The Chair: Thank you.

    Mr. Wilfert, please.

    Mr. Bryon Wilfert (Oak Ridges, Lib.): Thank you, Madam Chair. I would like to thank the governor and his colleagues for being here today.

    I'm going to pick up on the comments of my colleague. We've seen, until very recently, a very strong American dollar vis-à-vis other currencies in the world, including our own, the Australian, the New Zealand, etc. At the same time, if history is a judge, economic integration of states has inevitably led to political integration. There are forces at work, both here and elsewhere, that have argued for an integrated currency, a dollarization. One of the arguments that has been used, of course, is that the U.S. Federal Reserve already dictates the monetary policy in this country to a large degree, and we just follow or play catch-up. Clearly, we see that on interest rates, to a large degree.

    I don't think anyone is happy with the present state of the Canadian dollar. Yet when we look at the fundamentals of this economy--I'd like it if you could shed some light on this--they are very strong, in my view, and they're very supportive of a strong Canadian dollar. The OECD notes that we're the only G-7 country with a budget surplus. We have the largest tax cuts in history--in fact, the largest tax cuts of any of the G-7 states. We have a substantial current account surplus, which is obviously reducing our foreign debt. We have one of the best inflation rates of the G-7. We're improving our productivity and our competitiveness. Yet we presently see the dollar at levels that we have not seen.

    I guess my question to the governor and to your colleagues is how you account for this. Does it have to do with the American dollar being very overheated until very recently? Is it the fact that we're not getting our message out in terms of what's happening in this country? Is it simply the speculators? What is it? Given the fundamentals, why is it that we have the present situation?

º  (1605)  

    Mr. David Dodge: All that in 25 words or less.

    First off, there are two fundamental drivers that move bilateral exchange rates. One is what is happening in trade in goods and services and the movement of relative prices in terms of goods and services and the competitiveness in that market. What is absolutely the case is that as the Canadian dollar depreciated relative to the U.S. dollar, our industries became more competitive relative to the Americans. What we have seen is increased net exports to the United States, in fact markedly increased net exports to the United States.

    Now, normally, one would say, well, when that's happening it should be strengthening one's currency relative to the other currency. In fact, that tendency has been at work. But you, yourself, put your finger on a second very important point, and that is, capital flows here are extraordinarily important. In Canada, we have moved from a position in the early nineties, where we were net national dis-savers--with governments, as a whole, being dis-savers to the tune of 6% or 7% of GDP--to a position where we are net national savers, and we are exporting our savings to the world--with governments, as a whole, being net savers to the tune of 1% to 2% of GDP.

    Because of the fiscal action of Canada and the provinces, we accomplished that in a remarkably short period of time. No other country has made a move as rapidly as we did. That means that all of the capital we were having to suck in--and I go back to the first question--when we were having to issue a lot of debt in the early 1990s, we're now reversing that. The federal government is paying down debt. The Alberta government is paying down debt. Indeed, right across the country we have moved to a position where on balance governments are paying down debt.

    At the same time, households, while they are saving a slightly smaller fraction of GDP, continue to be saving, and certainly in the latter part of the 1990s, business was a substantial saver. So even though business investment went up, and it went up by about 2 or 2.5 points of GDP over that period, we were generating a lot of savings as a country. And they have to go somewhere. So there was an outflow of savings, and that outflow of savings--the reversal of what was going on earlier--was more than enough to offset the upward pressure that came from an improvement in exports.

    The savings investment balance is now more or less steadied out. So we don't have that huge downward pressure on the Canadian dollar vis-à-vis the U.S. dollar we had in the earlier periods, and we have a much stronger net export position. As one looks at it in the broad type of analysis the three of us do, there ought to be an upward movement vis-à-vis the United States because of actions that we in Canada have taken.

    Now, because it's a bilateral exchange rate, you have to look at the other side--what's going on in the United States?

º  (1610)  

    In the United States you find just exactly the opposite is going on: very little household saving, solid but not spectacular business saving, and government, which had moved into a fairly solid surplus position, moving back into a deficit position. The U.S. now finds itself in the position where now they are importing 4%, 5%, or 6% of GDP in terms of capital instead of the 1% or 2% that had been much more common early in the 1990s. That's continuing to put upward pressure on the U.S. dollar vis-à-vis other currencies.

    Finally, if you look at it in terms of the numeraire, taking the rest of the basket of countries against which we all trade in North America and using that as a numeraire, there's been very little movement in the Canadian dollar.

    It's a complicated story. There's a lot of short-term noise in the system that moves it around, but fundamentally those are the forces at work. At a time when the world economy is recovering, which tends to push up the prices of the products we produce and we export, not just to the United States but to the world, there tends also to be that upward pressure. That is why when I was in New York I said--I guess two months ago now--that the movements at that point in time when we were moving down weren't very helpful to the normal adjustment processes in the Canadian economy. At this point what we would hope for is some appreciation to take the pressure off the rising prices that naturally come with our exports at this point in the cycle.

    Mr. Knight spent years at the IMF watching many countries struggle with these issues, and I'm sure he could be more eloquent than I in responding to that.

    The Chair: Mr. Knight, five minutes, please.

    Mr. Malcolm Knight: Thank you, Governor.

    Actually, I just wanted to add one point. Mr. Wilfert, when you were listing a number of the positive aspects of Canada's performance, at the beginning of your intervention you mentioned that we have a lower inflation rate than the United States and many other of our trading partners. That's a very important aspect of our performance to remember, and I would just point out that we have consistently had a lower inflation rate than the United States for a large number of years now. That is a reflection of our monetary policy. We have a very explicit target of maintaining low inflation. We try to hit the middle of our target range at 2%, and in those circumstances we have to set monetary policy very much with conditions in Canada in mind.

    Going forward, we're going to continue to look very closely at what's going on here in Canada, how strong our economy is, and how quickly it's approaching potential in determining what interest rates should be in Canada given what's being done in other large countries, for example our neighbour to the south.

    Thank you, Madam Chairperson.

    The Chair: Thank you.

    Mr. Bryon Wilfert: I appreciate the fact that the governor didn't answer it in 25 words or less, and I appreciate the thorough response from both gentlemen. Thank you.

    The Chair: Thank you.

    Mr. Nystrom, you have ten minutes, please.

    Mr. Lorne Nystrom (Regina--Qu'Appelle, NDP): Thank you very much, Madam Chair.

    I have three different questions I wanted to ask the governor, and I want to welcome him once again to our committee with Mr. Jenkins and Mr. Knight.

    The first question goes back to your statement about raising the bank rate by a quarter of a basis point on April 15, up from 2% to 2¼% . I'll ask you to elaborate a bit more on why you did this. Are you revising your inflation targets from what they were in the past? I think Canadians want to know that. There's some concern about putting the moderate brake on the economy and about doing it at this time.

    Also, Madam Chair, I think you would be very interested in hearing this from the Bloomberg News this morning, that in New York on April 24:

Treasuries gained as government reports showed durable goods orders and new home sales unexpectedly fell, boosting speculation the Federal Reserve will wait until the second half of the year to raise interest rates.

    Since the American economy is so important to ours and since there's more and more evidence they are not planning to raise interest rates until well into the last part of this year, as is evident again this morning by the reports coming out of New York, why did you act when you did? Are you a bit concerned now in hindsight that you may have...not put the pedal to the metal, but might have been accelerating a little too quickly in terms of interest rates? Has there been a change of course in terms of your targets? Why accelerate at this time when what we see happening in the United States is probably not going to occur for some time in terms of them raising their rates?

º  (1615)  

    Mr. David Dodge: There are two questions there. That's okay. We'll start with those two first.

    Last fall we really put an extraordinary amount of monetary stimulus into the economy, extraordinary by historical standards, which took us to interest rates we haven't seen in this country for about 40 years. Why did we do that? We did that because there was a tremendous amount of uncertainty surrounding where we were going to go, and our judgment was that we should not take the risk of all the bad things happening; we should try to ensure that, as far as possible, we were supporting the economy and that there was, as we saw it at that time, absolutely no risk that we would have inflation pressures coming along quickly.

    So we moved a long way and put a lot of monetary ease into the economy. Now, as it has turned out, thankfully, we've ended much closer to that optimistic scenario we painted last fall, which we thought was probably the upper bound, and yet we've come pretty close to that.

    In fact, it's turned out that if you go back and look, we're actually pretty close to what we said a year ago, or what has happened is pretty close to what we said then, despite September 11 and those uncertainties.

    Given that, we are actually still operating a way from our potential--we still have a way to go--but we're operating much closer to it than we feared we might last fall. So it is appropriate to begin to take some of that monetary stimulus out, given what has happened over the last two quarters.

    That really brings me, then, to your second question: how come you guys who sit on Wellington Street are doing something and the guys who sit on C Street in Washington aren't? There are two reasons here. First, what the Americans have seen in the fourth quarter of last year and the first quarter of this year has largely been a reversal of the inventory cycle, whereas in Canada, we have actually seen final sales prove to be quite a bit stronger, certainly stronger than we had anticipated. We don't have the numbers for the first quarter yet, but our monitoring shows that in fact final sales will have grown twice as fast in Canada than they have in the United States. So it's not just the inventory cycle that's working here; there are other things working as well.

    Canadian export performance, particularly of smaller and mid-sized business, appears to have been extraordinarily good. Indeed, as we look at the numbers, we think small and mid-sized business are also doing something on the investment front, because what we're seeing is that imports of machinery and equipment are rising again. That's a pretty good gauge, since a lot of machinery and equipment that business buys is imported.

    So we think the situations here and in the United States are really quite different, and certainly in our situation it is appropriate to begin not to put on the brake but to put a little less gas going through the core.

º  (1620)  

    Mr. Lorne Nystrom: My other two questions then would be, first, about the structure of the national debt. My understanding is, throughout much of the 1990s, the majority of the national debt held by the Government of Canada was short-term debt. The Minister of Finance made a decision to transfer a lot of this short-term debt into long-term debt. About two-thirds of what I call the market debt now is long-term debt.

    Mr. David Dodge: Yes.

    Mr. Lorne Nystrom: This I think was done in 1997, 1998, and 1999. You may correct me on that if I'm wrong. But I think the structuring of debt went from short-term to long-term debt. This means that the minister has locked up our so-called national mortgage at higher interest rates than would have been the case if we had kept it as short-term debt--because the short-term interest rate has dropped. In fact, interest rates in general have dropped. But now we have our national mortgage at a higher interest rate, whereas it could be at a lower interest rate.

    So my general question for you is why the bank did not advise the Minister of Finance at the time that this might be an unwise thing to do. Didn't your crystal ball say that interest rates would be coming down quite sharply? If we have all this money locked up now at a higher interest rate--because of Mr. Martin's decision--we're probably paying $3 billion, $4 billion, or $5 billion a year more than we should be paying as Canadian taxpayers. So he may be the most costly Minister of Finance in the history of our country in terms of our national debt.

    So why didn't the Bank of Canada advise to the contrary? I think that's an interesting question to have answered, which a few people have asked me. Our market debt now is around $450 billion, while our non-market debt is around $100 billion. It adds up to an awful lot of money if we're paying an extra one or two points on interest rates.

    I probably won't get the floor again, so my next question is short and simple. Arthur Andersen is still doing the auditing, I think, for the Bank of Canada. I've noticed, Madam Chair, that Arthur Andersen was fired by the Ford Motor Company in the United States, by Federal Express, and by the U.S. government, but it's still the auditor for the Bank of Canada. What do you see in Arthur Andersen that those other institutions have not seen in terms of maintaining and retaining them as auditor?

    Mr. David Dodge: It's an extraordinarily good question, and your basic proposition is correct. After 1992, when we started to lengthen out the structure, had we continued to wait until about 1997, when we got to roughly where we wanted to be, we wouldn't have had a lot of that paper at 8% to 9% outstanding that we issued between roughly 1992 and 1997. Why did we do that?

    I have to plead personally guilty because I was Deputy Minister of Finance through that period. There was a decision, and when you sit at your desk and sign those warrants at 9% and we're headed for an inflation of 2%, you really worry a lot about what you're doing.

    We did it at the time because we had an enormous amount of federal debt outstanding. We were in a very fragile position. Had we been caught and had investors around the world, including here in Canada, begun to lose faith in us, we could have been caught in a situation of extraordinarily rapidly rising debt charges.

    As you'll recall, from about 1988 or 1989 until the early 1990s, one of the major reasons why federal deficits grew and grew was because interest rates were rising over the period and we had a lot of short-term debt. This was a risk management issue, and on balance at that time it was felt prudent to reduce the exposure, even though we knew that each year, as we were reducing that risk, we were adding around $1 billion of additional debt charges, going out into the future.

    In fact, we in Canada won the battle. In essence, we managed not to plunge over the cliff. Confidence has been restored and long-term rates are now down below 6%. But I'm not sure anyone who sat around this table in 1994, 1993, or 1992 would have been very confident. In fact, they would not have believed me, as Deputy Minister of Finance, if I had come in front of them and said that by 1998 we'd be down below 6%. It was a risk management issue.

    You're absolutely right that we are paying a price for mitigating that risk, and we'll pay somewhat of a price. It started to run off as we got out into the mid 1990s, but nevertheless I certainly did sign some of those warrants at 9%, feeling very uneasy about it.

    But that's the reason. It was a risk management issue, and indeed we at the bank--Malcolm Knight is driving this--are putting a lot of effort into continuing to improve our risk management practices, not just with respect to managing the federal government's debt, but in a number of other aspects of the things we do.

    Just turning quickly to Arthur Andersen, first of all, they are our auditor. As far as I know, there have been no problems with Arthur Andersen Canada, which is soon to disappear as Arthur Andersen Canada.

º  (1625)  

    Second, we at the bank have two auditors as you're aware--Raymond Chabot being our other auditor--and these auditors are selected for a five-year period, staggered, and they rotate. So far I can say that from the management standpoint at the bank, we think they've been doing a good job, and from the board standpoint at the bank, we think they've been doing a good job.

    The Chair: Thank you.

    Mr. Discepola, you have ten minutes.

    Mr. Nick Discepola (Vaudreuil--Soulanges, Lib.): Thank you, Madam Chair.

    Welcome, Governor.

    We received yesterday a group from the business community--mainly--who didn't express as much optimism about the economic recovery as you seem to. I'm reassured by your presentation because I feel that I do see some signs of recovery. They seem to indicate that the recovery is fragile at best, and I'm wondering what your position is.

    When you say you're easing off on the gas pedal, I get nervous because I'm not sure if you're implying by this that you're going to ease off on interfering with the interest rates if you can or with inflation. Which one are you targeting?

    When I see that there are some jurisdictions... I think the Federal Reserve in the United States, for example, doesn't even have inflation targets, and we see that their economy is plugging along. They've had higher productivity per capita than we have, higher economic growth than we have, and even a lower employment rate than we have. I'm wondering if you shouldn't get rid of the gas pedal and just let the market forces prevail, or can you assure us that the last rate hike was maybe just a blip?

    I get concerned, especially when I see that the real estate market is booming and construction demand is up because of the low interest rates. I'm wondering if you feel as the other group did, that it is fragile, or do you feel more confident than that, that intervention is required and maybe necessary? I think we all have the same targets and objectives in mind, to see economic recovery continue in Canada.

    Then I have another question, Madam Chair.

º  (1630)  

    Mr. David Dodge: Let me start off, Madam Chair, and then I'm going to pass it over to Malcolm.

    What is true in Canada and in the United States is that big business has suffered a profit reversal of significant magnitude, and this relatively low level of profit at the moment is making leaders of many large businesses rather wary about coming back and beginning again a major investment cycle. That is true on both sides of the border.

    What is true in Canada, however, where we are more oriented to medium- and small-sized business than in the United States, is that medium- and small-sized businesses have continued to do well through this slowdown--absolutely no comparison to what happened in the two previous slowdowns, where medium- and small-sized business got really hammered. They've continued to do well. They have continued to invest, and for that very large segment of the economy, the degree of fragility is not nearly as great.

    The second issue--and I'll ask Mr. Knight to elaborate on this a bit--is that the structure of our economy is different from that of the United States. Thirty percent of U.S. manufacturing is involved in either machinery and equipment or electrical and electronics. That fraction in Canada, while we don't have quite the same definitions around the edges, is somewhere between 15% and 17% in manufacturing--relatively speaking, about half the size of the U.S. sector. And telecom, which was a major driver, is weak in Canada--weak around the world--but again, it hasn't had as big an impact here in Canada as in the United States.

    That's not very much consolation if you're talking to BCE, Telus, or one of the large providers. But the sector that is relatively soft in Canada is considerably smaller than it is in the United States. So you have two differences that I think account for the rather different real effect on the ground.

    But I'm not surprised, having talked to--whatever they call themselves now--the CCCE two weeks ago myself, that you heard from them that they were a little bit more pessimistic, although if you'd asked Mr. Tellier, he would have told you that his volumes are up. He's just worried that they won't stay up.

    Malcolm, let me turn to you.

    Mr. Malcolm Knight: Thank you, Governor.

    As we move forward, there are clearly uncertainties in the situation. There are uncertainties at the international level with regard to the impact of geopolitical developments on oil prices and other things. There are uncertainties with regard to how quickly fixed capital investment will recover in the North American economy.

    But as the governor said, the fact that there are uncertainties is different from a situation that is fragile. We see right now that the strength in the Canadian economy is relatively broad-based. It's more concentrated in the smaller firms, which were actually more optimistic than the large corporations right through the period of weakening, continue to be so, and are finding some challenges in finding the workers they need and so on at this time.

    There are differences, as the governor said, in the structure. He talked about the fact that the high-tech sector is larger in the United States than it is in Canada, and that's a sector that is closely related to what will happen to fixed capital formation. We've yet to see where that will go.

    In Canada the construction and retail sales sectors have been doing well. In addition, on the export side, the primary product sector is a more important sector in our economy than it is in the U.S. As the world economy has been turning up, we've seen a marked increase in the demand for primary commodities. Primary commodity prices, both energy and non-energy, have actually been on a generally upward trend since November.

    So we have uncertainties in the picture, but that's a very different thing, I believe, from saying that the current signs of strength are fragile or only in a few sectors.

    The one other point I'd like to take up is the question of the explicit inflation target. I really think here that the performance of the economy in real terms in the 1990s under an inflation target was significantly better than it had been in the previous two decades, when we had very large variations in the inflation rate, which created a lot of uncertainty in the economy and weakened macroeconomic performance. I think it is one of the elements that's been important for the better performance of our economy over at least the past six, seven, or eight years.

    Thank you.

º  (1635)  

    The Chair: Go ahead, Mr. Brison.

    Mr. Scott Brison (Kings--Hants, PC): Thank you, all of you, for being here with us today. It's always a good session with you at the finance committee.

    We're at a point now where interest rates are low only because inflation is low. As they stand now, real interest rates are really not that low. Inflationary pressures are still virtually non-existent. I don't see the level of inflationary pressures that you envision. There is Middle East political uncertainty. Corporate profits are still very weak: in the fourth quarter of last year they declined by 19% from the previous year. Equity markets are still volatile. There is excess capacity in manufacturing, particularly in technology, as you mentioned. Unemployment rates are still significantly higher than those in the U.S.

    You used a car analogy earlier. I might try to do the same. Our economy now is still a Volkswagon-diesel economy in terms of growth and we're still north of a Mercedes-S500 type of economy. I guess I question, in terms of economic strength, this notion that Canadian economic growth is extraordinarily strong compared to that of the U.S.

    The only consistently positive indicators have been consumer confidence and spending in Canada. They have been largely buoyed by low interest rates and mortgage-driven liquidity. I have a real concern that you could jettison that confidence and consumer spending if we see fairly significant increases in rates over the next 12 months, because of the degree to which Canadians have fairly high residential mortgage expenditures now.

    I guess the only reason I can think of that you're raising rates now--if in fact inflation isn't a real risk right now, and if there's a real risk of damaging consumer confidence, which is critical to economic growth now--is that you're trying to in some way strengthen the Canadian dollar. You're trying to address what has become a vulnerability for the Bank of Canada and something that has become more of a political issue than it has been in the past. In polling, I think we're seeing that Canadians are more concerned about the weakness in the Canadian dollar than they have been before. It's becoming a real issue. Is that one of the reasons that you're increasing rates now, to try to strengthen the Canadian dollar? Is that part of your rationale?

º  (1640)  

    Mr. David Dodge: Let me first say, bluntly, no. Our objective is to try to keep the Canadian economy running along at about potential. Obviously, there are going to be little blips above and little blips below that. But if we can run along at about potential, then we ought to be able to have inflation at about 2%. If we get above potential, it's going to push inflation above 2%, and we then have to take action to try to pull inflation down. If we are below potential, then that indicates there's room to move and we can push interest rates down a bit. That, of course, is exactly what we did through the course of 2001, as we were moving from operating well above potential to operating well below.

    So that's what we aim at. Obviously we have to make judgments about exactly where we're going and the time path to get there, but it's a very clear objective.

    Now, where are we in terms of real interest rates at the moment? Short-term rates, which are commercial paper rates, are about 2.5% at the moment and inflation is about 2%. So the real interest rate is about 0.5%. This is quite a bit below what one would think of the normal neutral range of about 2.5% to 3.5% for real rates. So real rates are very low.

    If you look at long-term rates, they are currently about 3.5% versus an historical average of about 4%. So we are a little bit below average long-term rates, but not a lot. Long-term rates should stay relatively fixed now that we've dealt with our inflation issues. So I don't think your story is quite right with respect to interest rates.

    With respect to growth, of course, Canada has done better than the United States over the last three years. Where we didn't do as well was in the mid-1990s, because then we were tackling this very severe fiscal problem. Both the federal government and provincial governments were tackling this very severe fiscal problem, so we had a lot of fiscal restraint running through the system at that point in time. But it is just not true to say that Canadian growth overall has been slower than that in the United States.

    Mr. Scott Brison: The growth rates at this juncture may be marginally better, but the fact is we still have significantly higher unemployment than the U.S. and we still have excess manufacturing capacity. There are many people, including people in the business community, who think it's wrong-headed at this point to put on the brakes when we're starting to see some level of traction, particularly given the importance of consumer confidence in spending and the level of exposure, in terms of residential mortgages.

    Mr. David Dodge: But let's go back to what we said earlier. This is not the brakes; this is less gas. At current rates, we are well below something that might be considered neutral. So we're still providing a lot of monetary stimulus to this economy appropriately, but we're going to have to reduce the amount of monetary stimulus as we approach capacity. That's precisely what we are aiming to do, in a measured way.

    We don't know absolutely for sure that growth track we talked about is going to turn out. It could turn out stronger, in which case we would have to move more quickly, or it could turn out weaker, in which case we would move more slowly. But it is very important, as we know from past experience, to begin to move well ahead of actually hitting capacity. The effects of monetary policy on economic activity take--you pick a number because the lags are a bit variable--12 to 18 months, and then on inflation it's probably 18 to 24 months. In any case, it's later. So it is important to move in a timely fashion.

º  (1645)  

    Mr. Scott Brison: Some central bankers are starting to consider this whole asset bubble issue of real estate, equities, and share values. Are you considering these criteria, in addition to inflation targets?

    Mr. David Dodge: No, but I'll let Mr. Knight give you a full answer to that question.

    Mr. Malcolm Knight: Thank you very much. First, at the present time we don't see issues of significant concern in that area in Canada.

    I would also say that as a central bank, we always need to be looking at all of the indicators in the economy that suggest to us what is happening to demand and what is likely to be happening to prices. But our target is very clearly to maintain low and stable inflation. If we see pressure in a particular sector, for example in the housing market, it is a signal to us that maybe there'll be increased pressure on inflation down the line, and we need to take action on that.

    But getting back to the point the governor made, we're trying to manage monetary policy now, so we can move to and then maintain output growth at its sustainable level, without creating inflationary pressures. I would just submit to you that in the longer term, that kind of policy will give the best prospects for long-term employment growth as well.

    Mr. Scott Brison: I have one last question. Are you trying to get back to the situation where Canadian rates are traditionally higher--and in some cases significantly higher--than those in the U.S.? Are you trying to get back to that spread?

    I'm not saying it's politically motivated, but it certainly reduces the pressure on the government, and also on the Bank of Canada, if we have a stronger Canadian dollar. It's become a very political issue and it's on the radar screens. I believe that's part of your motivation to move to raise rates, when the fed is not doing that.

    Mr. David Dodge: Well, all I can say directly is no, but the level of the Canadian dollar does have, certainly over time, some impact on inflation. They're not totally separable, one from the other. We were surprised over the decade of the 1990s--and I'll let Mr. Jenkins talk about this because this is actually a very interesting thing--at how slow that impact was to come through, but nevertheless it is true that, generally speaking, a depreciating currency will put upward pressure on domestic prices and an appreciating currency vice versa. In terms of what we're trying to do for monetary policy, we have to set that policy appropriately for Canadian conditions, and we do not look at factors such as you said other than indirectly as the exchange rate may down the road have an impact on price levels.

    Paul, maybe you'd like to say a word, because you're the one who's studied this sort of thing.

º  (1650)  

    Mr. Paul Jenkins: I'll comment just very briefly.

    We have looked at this issue, and the question is, as exchange rates move, what are the price level effects in the economy? What we have found through this period of very low and stable inflation is that past relationships no longer seem to exist. You do not seem to get that same what we call pass-through effect. I think there's a general message here, which is, in this period of low and stable inflation, you're seeing economies much more stable overall, not just in terms of inflation performance but also in terms of economic performance. That's a significant difference from the boom and bust cycles we saw through the 1970s and 1980s.

    The Chair: Thank you very much.

    Ms. Minna, ten minutes, please.

    Ms. Maria Minna (Beaches--East York, Lib.): I want to look at a couple of issues. One is the area of the boom in the economy, which some people have touched on and which is happening right now. This is very encouraging to see, but from what we understand it's primarily consumer-led through consumer buying, and the businesses have not yet started to invest. Corporate investment has not really increased that much. I wonder if you could enlighten us as to your understanding of why that might be happening. Why is business lagging in terms of their ability to finance programs and projects and so on given the fact that inflation is low and also that interest rates are at rock bottom? That's one area.

    The other is just to give us an understanding as to why that's happening and whether you expect, looking in your crystal ball, for business to kind of step in anytime soon. Or is this a bit of a blip, and then are we going to go back to some difficulties, which I think we need to take into account as we look at other things?

    The other is the issue of interest rates. I know you say it's not even neutral in terms of the actions taken and what have you, but the consumers have--because of recoveries primarily in consumer spending--increased debt because of low interest rates, and they've bought more homes with mortgages and have bought other things. It's a psychological thing when things start to go up. Is that likely to cause a stalling, first of all, in consumer buying and spending because they'll perceive that interest rates are starting to go up?

    I know from talking to my own family...a member of my family who wanted to buy is looking very closely and is starting to get cold feet at the notion of getting out there. He's deciding whether to buy or not, whether to rush to do it right now before it gets even worse in the next two or three months, because his expectation is that it might go up.

    I'm wondering whether that will do two things. One is that it might cause the quick blip and then allow things to drop off, but also at the same time, if interest rates do go up, what happens to the debt load they have incurred as a result of maybe buying a lot more than they might have given the environment they expected? That was one area.

    Now I want to go back a bit. The other has to do with the rate of inflation. As you know, there are economists who believe the quest for price stability and the banding of inflation can actually cause, increase, or maintain higher unemployment rates in our economies. U.S. unemployment has been consistently lower than ours, and they do not have a specific band of inflation. Now, I notice you have 1% to 3%. I don't know whether 3% to 4%...maybe you can explain why you have a band, first of all, and whether or not in fact you see the correlation.

    To some degree, I think back to the huge unemployment rate we had in the early nineties and the recession we had, and it was common to talk about how the recession was a made-in-Canada recession, how it was deeper than that in the U.S. and other places, and how it was largely a result of the artificially high interest rates we maintained. I don't have to mention there were a large number of small businesses that went under during that process.

    My question is, is our obsession with maintaining low inflation also keeping a higher unemployment rate, and are we happy to have a higher unemployment rate at the cost of having a lower inflation rate? That's how I understand it.

    The Chair: Mr. Dodge.

    Mr. David Dodge: There are a lot of questions sandwiched in there, Madam Chair.

    I will do the easy part, and then I'll turn the inflation target issue over to Paul.

    First of all, the slowdown in North America in 2001 was really quite different from what we experienced in the early 1980s or the early 1990s in the sense that it was a classic investment cycle without a big policy correction overlay. You are absolutely correct that in the early 1990s we had a huge policy overlay on this that indeed made that cycle more difficult because we were trying to drive out of the economy 25 years of high inflation expectations. It was painful, but we ended up doing it. We now have an anchor, in the sense that our citizens firmly believe--and our businesses and capital markets--that basically while it may fluctuate a little bit, looking out into the future they can count on 2% inflation forever and ever. That is an enormously valuable piece of social capital that Canada basically squandered in the early 1970s, and we've paid quite a price to get it back. We now have it, and I can tell you that we at the Bank of Canada will do whatever we can to ensure that piece of capital doesn't get lost again.

    So what we had was a very classic--classic almost in the 19th century sense--investment cycle. We had overinvestment in certain sectors, telecom being a best example. Today one can see some of the fallout from that. We had a classic overinvestment, and some time at the end of 2000 people realized that too much investment had gone in, so they stopped. Then you had a huge investment retrenchment, while consumers, because labour income held up well in the United States and in this country, carried on.

    Have consumers gone heavily into debt in this country? Well, their debt levels relative to their incomes have gone up, but their debt levels relative to their assets remained about the same. So if you're asking us if we're particularly concerned about household debt levels at this point in time, the answer is no. If debt levels had gone up and assets had not gone up comparably, then of course there would be a problem. And the higher the level of debt, the slightly greater risk you have. But basically, the answer to that is no. We are not particularly worried.

    Is the very modest rise in interest rates that we have seen in the last month--or are likely to see in the next little while--likely to shut off consumption? The answer to that also is no. We still have low rates relative to people's expectations and where they're likely to be over the longer term, and that's what really drives things.

    What has happened, of course--and this is one thing that is very clear--is that the automobile companies took low rates and piled onto that additional incentives. So there were tremendous incentives to buy automobiles, and it is probably true that some purchases of automobiles were clearly dragged forward in time. We saw U.S. automobile consumption running last fall and during the winter at about 17 million units a year--a couple of million units above normal--which is very surprising at a time when U.S. unemployment rates were rising, and we've seen Canadian sales running at about 1.7 million above. So there may well have been some in respect of automobiles, but elsewhere in the economy we don't think so.

º  (1655)  

    I think that picks up, if I understood correctly, your first set of questions. I'll now turn to Mr. Jenkins. Did I miss one?

»  (1700)  

    The Chair: We'll let Mr. Jenkins finish that point.

    Mr. David Dodge: I'd like to turn to Mr. Jenkins on the second set, because that is the very critical underlying basis for everything we do.

    Mr. Paul Jenkins: That is indeed an excellent question. One way of thinking about it is in terms of the cost benefits of choosing an inflation target. With the 1% to 3% target ban we operate under, with a midpoint of 2%, which we aim at for achieving low and stable inflation, we also put a lot of emphasis on the predictability, the importance of having that explicit target. The predictable part is very crucial because it helps to anchor inflation expectations for savers, investors, and individuals looking forward. With those well-anchored expectations, it does facilitate the economic adjustments we have to go through.

    I could cite the example of the movement we've seen in energy prices. If you go back to the 1970s and 1980s when you were hit with a significant energy price shock, that very quickly was built into inflation expectations, which worsened the set of circumstances we had to deal with. So with a low, stable, and predictable rate of inflation, you do facilitate economic adjustment.

    Clarity on that objective, as we mentioned earlier, also facilitates the adjustment of policy in a symmetric fashion. When we see inflation pressures easing, that's a sign we need to adjust monetary conditions downwards. Likewise, when we see inflationary pressures building up, we adjust monetary conditions in the opposite direction.

    To get to your specific question of why 2% as opposed to 3% or 4% and the link to unemployment, this does get into a very important set of issues. When we renewed our inflation agreement with the government in the spring of last year, this is one of the key questions we looked at. With all the research we could bring to bear on this question, both internal and external, drawing on researchers from a number of different sources, we came to the conclusion that an inflation target at 2% was not having detrimental effects on the ability of this economy to operate at full capacity and full employment. So we did not see any evidence that at a 2% target rate of inflation, that was, as you suggested, leading to any increase in the unemployment rate. All the research we have done continued to support that rate of inflation target at 2%.

    The Chair: Thank you very much.

    Next is Mr. McNally.

    This is a five-minute round. Hopefully, I can fit everybody in if we all stick to the time allowed.

    Mr. Grant McNally (Dewdney--Alouette, Canadian Alliance): Thank you, Madam Chair.

    I want to follow up on the dollar. It seems amazing that we have a dollar that's hovering just over 60¢. I want to follow up on what you mentioned earlier. You said that as the dollar has dropped, exports have become more competitive. You also said that we're a nation of savers. It seems that an unanticipated by-product of the low dollar is that many sectors of the economy have in many ways an unintended subsidy when dealing with sales into the U.S. I was wondering whether or not you would agree with that.

    Also, what can the Bank of Canada do in terms of the low dollar? While it may help some sectors of the economy, it's quite clear that it hurts others quite profoundly. Are we going to be living with a 60-some-odd-cent dollar for the rest of our lives? We seem to have come to accept it to some degree. What do you see as the answers there?

»  (1705)  

    Mr. David Dodge: In setting monetary policy we have one lever and we can have one anchor. The two regimes that one can choose for an anchor are, roughly, to peg your exchange rate with somebody or to operate in such a way that you have an inflation target. Now, there are variations on both, but essentially there are only two ways to work.

    We have chosen in this country to operate with an inflation target and a floating exchange rate. We've chosen it, I think, for all the right reasons. A fixed exchange rate for us would mean that what we would have to be prepared to do is to move all the prices in our economy as the terms of trade or the relative prices of what we export and what we import change. For good or for bad, it just happens to be a fact that our prices are relatively volatile in this country. There's quite a bit of movement in this. Hence, it is really quite advantageous for us to have the floating currency.

    But you do need an anchor--that's the one thing we learned from our not very great experience in the 1970s--and that anchor has to be understandable. Parliamentarians have to understand it. Citizens have to understand it. Markets have to understand it. When we had an anchor back then--and we did have one; we picked the monetary aggregates as our anchor--no one could understand it, and it proved that it wasn't such a good anchor anyway. It kind of dragged a lot.

    We now have what we think is a good anchor. Indeed, most countries around the world are adopting the regime we have pioneered since the early 1990s. That means that the exchange rate is going to be what the exchange rate is. At the moment--I carry the numbers with 1992 as a base because we all calculate it that way--we're at about 95¢, 96¢, or 97¢, in that territory, for our exchange rate vis-à-vis our trading partners, other than the United States. There's been a tiny depreciation over the decade vis-à-vis our other partners, but there has been a significant depreciation vis-à-vis the Americans.

    Now, 90¢ is very high. We had been at about 75¢, but nevertheless.... Putting it differently, the Americans are at about $1.25 vis-à-vis the rest of the world, so they've moved up vis-à-vis the rest of the world, we've moved down a tiny bit vis-à-vis the rest of the world, and that appears to have opened a fairly large gap.

    Will we stay there? I don't know. There are forces I outlined earlier that say that over the next few years we ought to move up. There are forces at work, as Bill McDonough, the president of the New York Fed explained, that ought to move the U.S. down vis-à-vis the rest of the world over this period. But those are forces at work, and exchange rates tend to be a little bit more volatile than the underlying forces.

    The Chair: Thank you very much, Mr. McNally.

    Ms. Leung, five minutes, please.

    Ms. Sophia Leung (Vancouver Kingsway, Lib.): Thank you, Madam Chair.

    Welcome, Governor, Mr. Jenkins, and Mr. Knight.

    We have heard a lot of speculation on a currency union between the U.S. and Canada. I wonder if this is feasible or probable for Canada. I would also like to know, what are the advantages and disadvantages?

    My second question relates to the fact that in February the inflation rate was around 2.2%, and it is still relatively low. However, why is the Canadian savings rate... and the consumer debt loads are higher? Can you tell me the reason? Is it because of the low Canadian dollar?

»  (1710)  

    Mr. David Dodge: In talking to members of Parliament, I never comment on whether a currency union is probable. That is your decision.

    Is it feasible? Yes, it's feasible, but that doesn't necessarily mean it's desirable. I'll go back to what I said earlier. Normally it is important, if you want to get to a currency union, to first get to a single market. If you don't and you're in a currency union, labour cannot move back and forth across the border and you run the risk of having your exports stopped by a southern lumber lobby, or whatever. Then you are in an extraordinarily difficult position.

    You need to establish a single market and take away the potential that your exports can be stopped; or--we've lost Mr. Nystrom--that the Americans can run a witch hunt against an effective marketing operation, like the Canadian Wheat Board; or block Canadian service providers from providing services in the United States; or that a Jones Act doesn't allow our ships to operate there. Until you do all those things, it is extraordinarily dangerous to move into the currency union. That's not to say you couldn't do it, but it would be dangerous.

    On the consumer debt issue, I guess I wasn't very effective in responding to the previous question. Much of the rise in consumer debt that we've seen in Canada over the last 12 months has come about because Canadians have taken on increased mortgage debt. That's partly because house prices have been rising more rapidly than in the past, but also in part because they've been buying new houses at an almost unprecedented rate.

    In essence, because they've been taking on this debt to acquire assets that will yield a stream of real income to people over a long period of time, we are not particularly concerned that this is bad. It does make the housing sector slightly more fragile, slightly more exposed to potential rising rates or a sudden drop in labour income. There's no question about that. But basically, because of what it's being used for, it doesn't seem to us to be so bad.

    Even a lot of non-housing consumption, as we said earlier, has gone into purchasing new automobiles, which will again yield a stream of services over a period of time. I got rid of my 1989 car last year and bought a 2001 model in one of those deals. That means I won't have to buy an automobile for the next ten years. So even in what we call consumption, there's an element of putting an asset behind it. That is particularly true with respect to things like automobiles and other consumer durables.

»  (1715)  

    The Chair: Thank you very much.

    Mr. Marceau is next for five minutes.

[Translation]

    Mr. Richard Marceau: Thank you, Madam Chair. I have two quick questions for the Governor.

    One basic theory associated with monetary policy is, of course, the theory of an optimum currency area formulated for the first time in 1961 by Robert Mundell, a recent recipient of the Nobel Prize for economics. Recently, Mr. Mundell publicly professed his belief in a monetary union between Canada and the United States? How do you respond to his statement? That's my first question.

    Secondly, you stated that the Canadian and US economies were substantially different. That may well be true, but surely you're aware of a study by Professor Coulombe of the University of Ottawa. In his study, the Professor notes that economic cycles in Ontario and Quebec differ from cycles in other parts of Canada, that increasingly, these were more closely align with US economic cycles and that in the case of these two provinces, the economic heartland of Canada, the solution lay in a monetary union with the United States. What is your reaction to this study?

    Mr. David Dodge: I'll answer the second question and let Mr. Knight take the first.

    Mr. Malcolm Knight: Professor Mundell did in fact discuss the whole issue of a monetary union at some length. In fact, two weeks ago, he gave a speech at Carleton University. He advocated an optimum currency area on a global scale.

    Professor Mundell argued that a global optimum currency area would lower the cost of transactions in all countries through more efficient international transactions. Cost reductions would be significant, but no one knows exactly what the savings would be.

    However, as the Governor pointed out, before this kind of monetary union becomes a reality, markets around the world need to operate with greater flexibility. Transactions between nations must be more flexible. I'm not only talking about goods and services markets, but about production factors markets, including labour markets.

    To achieve this level of monetary union, it's important for national markets to be very well integrated. At present, this isn't the case with production factors markets. Therefore, as you mentioned, this is a matter for further discussion, but for now, I don't believe this is the best approach to ensuring sound macro-economic performance here at home.

    Mr. David Dodge: Professor Coulombe stated - and the trend supports his contention - that generally speaking, the economies of Ontario and Quebec are much more similar, from a structural standpoint, to the US economy than to economies in other parts of the country. Southern Ontario and southern Quebec more closely resemble the US midwest than other regions of Canada. Despite the similarities, however, fairly major differences exist.

    Canadian industries in Ontario and Quebec are much more concentrated and specialized. In Ontario, for example, the automobile industry represents a much bigger component of overall output than is the case in the United States. The aerospace industry in Quebec accounts for a substantial percentage of total economic output.

    Professor Coulombe is essentially right: the Ontario and Quebec economies are more similar to the US economy, but they are by no means identical to it. The real question, and one to which no in this room can provide an answer, is whether in future, the economies will grow even closer or whether we will become more specialized and more vulnerable to fluctuations in relative prices. I can't answer that question.

»  (1720)  

[English]

    The Chair: Thank you very much.

    I have two more people on my list right now. I realize that you have to leave by 5:30 p.m., Mr. Discepola and Mr. Penson, so I'm going to give you the final...

    Mr. Brison, you had not indicated.

    Mr. Scott Brison: I'm fine.

    The Chair: Mr. Nystrom, you're fine too?

    Mr. Lorne Nystrom: Yes.

    The Chair: Okay.

    Mr. Nystrom is behind you.

    Thank you. We'll be able to finish on time then.

    Mr. Discepola, you have the floor.

    Mr. Nick Discepola: Thank you, Chair.

    Governor, you've stated twice now that our economy structurally is much different from the United States. You've given other macroeconomic differences between our economies. Yet you said a monetary union is feasible. You didn't discuss the merits of it.

    The whole debate about monetary union--you use the words “currency union”--is really a smokescreen for whether Canada should adopt the U.S. dollar. The bottom line is, whether we're a fully integrated economy with the United States or not, we are never going to be able to convince the United States to adopt a “nora” dollar, or whatever you want. So why don't we just cut to the chase and say, should Canada adopt a U.S. dollar or not? And that's open for debate.

    But I find it strange that we're being lulled into this discussion. I understand where the Bloc Québécois is coming from, because during the last referendum they promised everybody that they could keep their dollar, they could keep their economic union with the rest of Canada, they could keep their passports, and so on. So they have a self-interest. They want to preserve their reason for being here.

    I understand also the premier of my home province saying that separation is dead, welcome to sovereignty association, which is inspired by the European model. They come from the same head office, so they understand their dialogue a bit. But I'm intrigued as to why you think we could possibly move to that. I'm taking your comment very strongly, that you've prefaced it by saying, in your opinion, only once we have achieved a full economic union should we even contemplate a monetary union.

    I don't see the craving amongst my constituency to adopt the American dollar. When I tell them all of a sudden their $100,000 home is going to be worth $60,000, and when I tell them that just because they adopt the same currency, their cost of living is not going to decrease or stay the same, they all of a sudden lose the appetite, because when they travel....

    I haven't travelled as often as I used to in the United States, so I don't know what the price of regular staple goods is, but I think it's essentially the same. A basket of staple goods is probably the same as it is in Canada, but in U.S. dollars.

    So isn't it a false debate saying we are going to achieve a common currency? Shouldn't we just be saying, let's continue our efforts as we did pre-September 11 to try to integrate our borders, to try to get free movement of goods and services with the United States? There's an interest even there with Mexico, but let's forget this idea of a monetary union, because I think it will never happen, unless we're willing to adopt the U.S. dollar.

»  (1725)  

    Mr. David Dodge: Let me try to take this in order so it's quite clear where we are. As I said, it is up to Parliament and parliamentarians to make those decisions. I can't deal with those issues.

    But let's step back. At the moment, and for the foreseeable future, from an economic point of view--for the economic interests of Canadians--we are better to have a regime where our monetary policy is anchored by an inflation target and we have a floating exchange rate than to adopt a fixed exchange rate, a common currency, or the American dollar--it doesn't matter which of those modalities you pick--because of the difficulties we have making adjustments in an economy where the relative prices between Canada and the United States are quite volatile, and where the savings and investment patterns are quite different. When you operate with one less price in the economy, it means everything else has to do a lot more adjusting. That adjustment can indeed be quite painful.

    Second, if you believe we ought to be pursuing and going down the path of closer economic integration with the United States, then the place to start is not on the monetary side. The place to start is to continue to deepen the market for goods and services to truly make it a single market, and to integrate the labour markets. You may not want to do that, but if you say you really want integration, that's where you start. The monetary side follows in the end.

    The final point is that from an economic standpoint, it really doesn't matter whether it's a currency union or we adopt the American dollar. It certainly matters from the point of view of discretion in terms of policy. You would like a say, just as the Dutch had a say in the direction of European monetary policy. If we couldn't get a say, then there would be a good reason not to want to do it.

    And there is this other issue of seigniorage. It's not as important; nevertheless, the Bank of Canada turns over to the Government of Canada about $2 billion a year of profits, which you would prefer be turned over to Canadians rather than Americans. So there are issues there.

    But fundamentally, if you really think on the integration front, then you don't start on the monetary side. If you want the best economic performance, certainly for the foreseeable future, you stay with a floating exchange rate despite the fact that it does have, itself, some costs. But those costs are lower than the benefits.

    Let me just say one word to conclude, Madam Chair, if I might.

    In my first year as governor I had a great advantage in that in every meeting we had, we lowered interest rates. And governors are not so unpopular when rates are coming down. I expect I will be less popular when I come back and see you next fall or next spring.

»  (1730)  

    What is really, really important to understand is that what we're all doing--what the fiscal authorities are trying to do and what we are trying to do--is basically to get as close as we can to the maximum rate of growth and maximum level of output that the economy can sustain without pushing us into a period of inflation, on the one hand, or a lot of unnecessary unemployment, on the other hand.

    Coming back, we've talked a lot about the auto sector and gasoline and so on today. Let me just conclude by saying that we're not a VW economy, or a Mercedes economy, but an economy with the name of another car. Thanks very much.

    The Chair: Thank you very much, Mr. Dodge. On behalf of the committee and all members, we very much appreciate your answers to our questions today.

    Thank you very much, Mr. Penson.

    We are adjourned.