Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 17 - Evidence
OTTAWA, Wednesday, April 30, 2003
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:00 p.m. to examine and report upon the present state of the domestic and international financial system.
Senator E. Leo Kolber (Chairman) in the Chair.
[English]
The Chairman: With great pleasure on behalf of the Senate Standing Senate Committee on Banking, Trade and Commerce, I welcome David Dodge, Governor, Charles Freedman, Deputy Governor, and Pierre Duguay, Deputy Governor from the Bank of Canada.
Mr. David Dodge, Governor, Bank of Canada: Thank you, Mr. Chairman, it is a great pleasure to be here today. We appreciate having the opportunity to talk to you following the release of our semi-annual monetary policy report.
It is really important to us that we explain to you our views on things. I would like to say a few words about the report we released last week. First, however, I would like to introduce my colleagues Charles Freedman and Pierre Duguay. This will be the last time that Mr. Freedman appears before you because, much to our chagrin at the bank, he will soon retire after 30 years at the bank. He has provided tremendous leadership to us in the area of monetary policy of financial institutions and Canada's clearing and settlement systems.
[Translation]
The last time I testified before this committee was in the spring of 2002, because we were unable to arrange our regular meeting last fall. As you may recall, our schedule was interrupted by Mr. Manley.
You will also recall that following the September 11, 2001 terrorist attacks in the United States, we quickly and aggressively cut our policy interest rate to shore up confidence and support domestic demand. By last spring, evidence had already started to build that demand was growing faster than the economy's production capacity.
Monetary policy actions must always be forward looking. So, even though demand pressures were not yet showing up in prices, we raised our key policy rate three times between April and July 2002.
By the autumn, inflation was on the rise. However, we refrained from raising interest rates because of geopolitical and financial uncertainties, high yield spreads and restricted access to funding for riskier corporate borrowers, as well as the expectation of weaker foreign demand for Canadian goods.
[English]
Since then, inflation has been above the 2 per cent target midpoint. The total CPI inflation peaked at 4.6 per cent in February, falling back to 4.3 per cent in March. The jump in inflation reflected a sharp rise in oil and natural gas prices, increases in insurance premiums, and strong domestic demand that led to price pressures in certain sectors such as shelter and some services. In this environment, certain indicators of short-term inflation expectations have edged up, although longer-term expectations remain around 2 per cent.
Core inflation, which, as you know, strips out most of the volatile items, is a better indicator of the future trend of inflation. It now sits around 3 per cent, but it should fall to about 2.5 per cent in the second half of this year, and to 2 per cent in early 2004.
Total CPI inflation will continue to fluctuate with swings in crude oil prices. If these prices settle at about U.S. $25 a barrel by mid-2003, as futures prices suggest, and if the Canadian dollar stays close to current levels, then total CPI inflation will likely fall temporarily below the core rate in the first half of 2004 before steadying out at a rate close to core.
In view of the domestic inflation situation and the underlying momentum of domestic demand, we raised our target overnight rate by 25 basis points on each of our last two policy announcements dates. It now stands at about 3.25 per cent, which is still quite low by historical standards.
Some of the geopolitical and financial uncertainty we saw last fall has lifted in recent months. We expect that it will continue to recede. Economic uncertainty in some regions of the world is, however, still a concern. Yet, overall, the risks confronting the world economy now appear to be better balanced than they were last fall, and business and household confidence should improve by year-end.
In Canada, domestic demand has remained quite strong. However, there is uncertainty about the economic impact of SARS, particularly in the Greater Toronto Area. Second-quarter growth will likely be somewhat weaker than we originally projected as a result of SARS and while the developments of the past few days suggest the worst is behind us, it is too soon to put a number on the effect of SARS on the economic activity.
Looking forward, the Canadian economy should strengthen toward the end of 2003, partly thanks to a pickup in U.S. economic activity. Average annual growth in Canada is expected to be about 2.5 per cent for this year. During 2004, our economy should expand at a rate above its 3 per cent growth potential, and, therefore, most of the small amount of economic slack that is likely to open up this year will have closed by the end of 2004.
For this reason, we still believe that further reductions in monetary stimulus will be necessary over time to reduce inflation to its 2 per cent target and to sustain output levels close to capacity. The timing and pace of further increases in the bank's policy interest rate will depend on the strength of domestic demand, the evolution of inflation expectations and the pace of economic expansion in the United States and overseas.
We will now be glad to answer your questions.
Senator Meighen: As you know, governor, I am from Toronto, which I should have admitted perhaps in a soft voice, but we are no doubt overly pre-occupied. It is not snowstorms this times; it is SARS. We, along with most observers, are certainly convinced that it will leave a negative impact on the economy, not just Toronto's, but probably Ontario's as well and, therefore, by implication on the rest of the country.
In your monetary policy report you were predicting, I think, a growth rate between 2.5 per cent and 3 per cent, if I am not mistaken. Is that correct?
Mr. Dodge: It will be about 2.5 per cent.
Senator Meighen: Knowing what now know in terms of SARS and the continuing sluggishness of the U.S. economy, would have you raised interest rates as you did or would you have left them where they were?
Mr. Dodge: With the exception of the uncertainty related to SARS, there is certainly nothing we have seen since the last date on which we set interest rates that would have caused us to change our mind. We said at that time that we believe that we would start to see a pickup in U.S. investment — which is the key issue that has been sluggish south of the border — some time late in this year. We looked for a U.S. economy to grow at about 4 per cent through the course of 2004.
As you know, monetary policy only has its effect over a fair period of time. In looking forward to that, there is nothing that certainly has occurred since our last interest-setting date that would have caused us to change our mind.
With respect to SARS, none of us know how big or how long lasting that impact will be. We are all encouraged that in the last 10 days or so we seem to be getting the issue under control, if not totally behind us. With the fact that the sun is finally shining outside, we may see activity come back really quite quickly. We do not know. No one can know. All we can do is give the medical community our full support as they struggle to finish getting this epidemic under control.
Senator Meighen: Your next date at which you raise, lower or leave alone the interest rate levels is early June if I am not mistaken. Is that correct?
Mr. Dodge: Yes.
Senator Meighen: My notes say June 3.
Mr. Dodge: Yes.
Senator Meighen: You will set them again on July 15. In the last paragraph of your report, you seem to say that the day is done and that it looks like interest rates will be rising.
I would have thought that the economic picture that we were just discussing would lean the other way. There are some indicators that do seem to suggest that the economy in the U.S. is not recovering as we might have predicted and hoped. Mr. Greenspan had something to day about that today; perhaps you have read it. If that is the case, I would be surprised if you would want to raise interest rates in June or July.
Mr. Dodge: I am glad you asked that question. The timing and pace increases are going to take place over time because we are well below the norms that one might expect over the longer term. These increases will depend on the strength of our domestic demand. We expect that over the first three-quarters of this year that demand will evolve at a pace just slightly below the rate of growth of potential of the economy.
Second, regional offices monitor closely the devolution of inflation expectations. We watch that on an ongoing basis. We watch closely the pace of expansion in the U.S. and overseas. Those are all the factors that we have to take into consideration each time we meet.
We look out 18 to 24 months. We expect that we will be operating certainly towards the end of 2004 at close to capacity. Some further removal of stimulus over that horizon will indeed be appropriate. We want to make that fairly clear and give people a longer-term view.
Senator Meighen: I suspect that one of the questions that will not play as great a role as it has in previous meetings with you is the issue of common currency with the United States.
I know your views, but I would like that you to elaborate on them. To what extent has it helped you to have the ability to act independently? What would have been the consequences had we had a common currency?
Mr. Dodge: I can answer that very simply. It has been tremendously helpful through a period when we have been operating much closer to capacity than has the U.S. economy. It is very helpful to be able to set monetary policy appropriate to conditions in each jurisdiction where such policy is set.
If I may back up one step, we have seen a fairly rapid depreciation of the U.S. dollar — not just against Canada but also against Australia, U.K., and the euro. It is not totally unexpected.
You will recall that we talked about this issue when we met here in the fall of 2001. At that time, we said that we did expect that there would have to be some adjustment because the U.S. currency had appreciated quite strongly on the back of very strong capital inflows with a major current account deficit. At some point, adjustment would have to take place.
We are all good at getting direction but timing is always difficult. We are seeing that adjustment taking place quite rapidly as it has turned out over the past four months. However, the very adjustment that we had anticipated is taking place.
Mr. Charles Freedman, Deputy Governor, Bank of Canada: Furthermore, the exchange rate and the ability to adjust interest rates have been a tremendous shock absorber in both direction. In 1997-1998, during the East Asian crisis when raw materials prices plummeted, the fact that we had the exchange rate depreciation in Canada enabled us to lower interest rates to help cushion our economy at a difficult time.
When people ask me about a fixed exchange rate and monetary union, I ask them to consider what the case might have been had we been at U.S. 75 cents at that time. We would not have had the ability to have it cushioned by the decline in the exchange rate and the associated sharp rise in non-commodity exports to the U.S. and elsewhere.
More recently, we have out-performed the United States. In those circumstances, having the ability to raise interest rates more than the U.S. did — in fact they have lowered them while we have raised them — reflected the fact that the two economies are performing different.
You see the differences around the world. Interest rates are as low as 0 per cent in Japan and as high as 5.5 per cent in New Zealand. This reflects the fact that countries do use the opportunities provided by a flexible exchange rate and the ability to adjust their interest rates to set the monetary conditions in their economies to suit domestic conditions.
If our economy moved in lockstep with the U.S., that would not be necessary. However, it does not, as we have seen over the last two decades.
Senator Kroft: As are you probably aware, this committee has been engaged since last June in an exhaustive study of the impact, effects and results on the economy of a number of the corporate disasters in the U.S.
It has been long enough that when we started out it was post-Enron. We have added a number of companies to the list since then, so we have redesigned the title.
One of the benefits of taking that amount of time is that, in addition to studying, we have been able to monitor the changes in the responses and the legislative and regulatory developments in the U.S., which are obviously important in both their impact on the macro-market and specifically on any regulatory areas on Canadian inter-listed companies.
We have had the opportunity to talk to an enormous array of Canadians involved in or having views on this subject, in one way or another. We recently spent the better part of a week in New York and Washington, during which we were able to see most of the key people engaged in this issue, including your counterpart, Mr. Greenspan.
All of this is directed at trying to produce a report — which we will do shortly — and to make some useful policy observations on what is required to restore public confidence in capital markets at all levels. Fundamentally, that is what it is all about.
Since we are just drafting our report, your timing here is very opportune. I would find it very useful to hear your thoughts on where you feel confidence levels are. Obviously, the U.S. is highly relevant, but I would also like to know your views about Canada, in terms of capital markets.
What indicators or what capacity do you have to judge confidence levels in these markets, because that is obviously an important component? You talk about confidence at the consumer level, but how do we judge, how do you judge and what conclusions might you help us draw on where we are in the process of restoring confidence levels in capital markets?
Mr. Dodge: That is an extraordinarily good question, but equally difficult to answer clearly and succinctly.
I think we all realize that the time itself does act as a healer. We have not seen any more stuff coming out of the woodwork, so there is beginning to be some feeling that the worst is behind us. There is not a lot more bad news to come.
Furthermore, in light of what has happened and the uncertainties that this has created, boards of directors and senior management, including CEOs, have become rather cautious and risk-averse. While we may have had a period prior to 2001 where unwarranted risks were being taken and where the pressures were to account for things in a very rose-coloured way, the current pressures on boards and CEOs are on the other side. We are seeing some degree of risk aversion that certainly was not there and a concentration, as you will have observed, of CEOs and boards ensuring that they are ``clean'' vis-à-vis accounting and corporate governance measures. Boards doing this have spent a tremendous amount of valuable time — time that they have not then had to think about future business plans.
I think this is fairly common. Certainly, it would be the view of our colleagues that this is getting behind us. It is not behind us, but it is getting behind us. Certainly once we get through to the fall, then it will be largely cleaned up. The view is that the new regulatory frameworks are, by and large, helpful. The rules pertaining to degree of detail are, of course, causing some degree of concern.
Finally, there are clearly some major issues on the accounting side — not only for the United States or Canada, but also around the world — in terms of some of the way accounting is done and the effects that that accounting has on real business decisions.
Our view is that progress has been made, both here and south of the border. More progress will be made, but the issue will not be fully behind us for a little while yet.
Mr. Freedman has to deal with this in terms of financial stability all the time and he may want to add some comments.
Mr. Freedman: You asked what we monitored. One of the things we monitor is the flow through the capital markets. What we saw — especially at times when there was a lot of concern about the accounting framework and the numbers we were seeing — was a drying up of the ability of corporations to access credit markets. More recently, we have seen, particularly in Canada, a substantially increasing flow of bonds through the markets. It is still mostly the better names; however, you see some of the others as well. There is, in fact, a fairly strong demand for corporate bonds on the part of investors. We have seen a real pickup on that side.
I would also like to draw your attention to an interesting speech by Ben Bernanke, a governor of the Federal Reserve Board, on April 24, in which he talked about the question of expectations and confidence among corporations, related to various things. In the end, after looking at all the factors, he came to the view that an investment bounce- back of moderate proportions is a reasonable expectation. He was not expecting a sharp bounce-back, but rather a reasonable improvement in circumstances. Part of it relates to a lessening of the geopolitical problems; however, part of it does relate to an improvement in attitudes as these various boards get into operation and as people begin to feel a little confident in the numbers.
Senator Kroft: You were talking about bond flow. A lot of the drive in the perhaps irrationally exuberant but certainly dynamic market was in the high-yield. Junk became high-yield. Do you think the size and scope of that market will return? Or, was the scale of the high-yield market a lesson learned?
Mr. Freedman: There are two points. The high-yield market in Canada was much smaller than it ever was in the United States. It started to develop in 1997-1998 and came back down. It was never really that important. Most of the high-yield borrowers went to the United States market over that period of time.
More generally, if you look at spreads, although they have come down and narrowed, they are still quite high by historical standards. This is particularly true for high-yield companies.
I think it will be a long time, if ever, before we get back to those heady days when you could sell anything. People are more skeptical now. They are asking for higher returns to offset the higher risks. That said, that market will continue to function, but perhaps with a more realistic set of expectations.
Senator Oliver: My question, like Senator Kroft's, is about investor confidence, and post-Enron.
The Bank of Canada has said that it is committed to being very transparent about its policy intentions. Indeed, in your report on page 7 you say that, ``the Bank's commitment to openness and public accountability is also integral to achieving its key policy objectives.''
This would also benefit investors because they can better anticipate the bank's reading of key economic data, and transparency also relates to investor confidence, which is important to the effective functioning of our economy.
Two weeks ago, on April 15, The Globe and Mail carried a story that said the Governor of the Bank of Canada regularly meets to discuss what kind of securities reforms Canada should introduce with Mr. David Brown of the Ontario Securities Commission, the Deputy Minister of Finance Kevin Lynch, the Superintendent of Financial Institutions Nicholas Le Pan, and Douglas Hyndman of the B.C. Securities Commission. The paper reported that the intention of those meetings that have been ongoing is to shore up investor confidence following the Enron scandal.
Given the bank's statement that it wants to be transparent, and bearing investor confidence in mind, what is the bank's policy intention flowing from those meetings?
Mr. Dodge: The paper did not quite have it right. We started meeting the heads of agencies a little earlier than Enron broke. We started to have those meetings — it is surprising we had not done it historically — as a result of concern that we all had as to the development of Canadian capital markets and the health of Canadian capital markets and what we ought to be doing in terms of sharing our knowledge between the various agencies that were concerned. That is the broader context. Then Enron came along, which tended to focus us in a particular direction.
Our main objective here is not to operate in isolation of one another. Obviously, Nick Le Pan is the regulator of banks and insurance companies, a very important role from the prudential side; the Securities Commissions has a important role from the market side; and our concern is that we need a well-functioning Canadian financial market to provide credit appropriately to Canadian individuals and businesses to ensure that government debt can be sold in a well-functioning market. It is through that well-functioning market that we operate in terms of monetary policy in the transmission of that policy through that market.
Essentially, what we have continued to do in our meetings is to address those broad concerns and share information about the development of Canadian markets. Mr. Freedman mentioned the issue of high-yield bonds, which has not been a large market in this country. We look at reasons why that market has not developed as vigorously here in Canada as it has in the United States.
That is the purpose of that group. We try to meet about three times a year.
Senator Oliver: I was not so much asking about the purpose. I talked about transparency. Given this new transparency that you and the bank state you will have, will you share with Canadians now what you have learned and what you would like to see by way of new securities regulations as a result of the series of meetings with these other key officials?
Mr. Dodge: We are not securities regulators. We have been trying to look at the efficiency of the operation of those markets. We have produced several papers on the subject, which are on our Web site. We have been looking at such issues as whether there is a discount of Canadian equity to U.S. equity because we are Canadian. Michael King wrote a paper on that issue, We are — is it fair to say? — the research arm of this, as opposed to the regulatory arm. Indeed, it is helpful that we do not have regulatory responsibilities because we are able then to focus on the analytics of what goes on.
Mr. Freedman: A colleague and I conducted a study, which is publicly available — on what are the facts. You heard a lot of people worrying that in this globalized world Canadian financial markets will disappear, the same way Boston and Philadelphia became small relative to New York, or Birmingham and Manchester became small relative to London. What will happen to Toronto, Montreal and Vancouver?
If you look at the data — and this is something that perhaps gets done less than it ought to — you can see that Canadian borrowers have used Canadian debt markets for about 50 per cent of their borrowing for the last 20 years, and the figure has not decreased. Is the glass half empty or half full? Is 50 per cent enough? Among the things we would like to look at is who is borrowing in the U.S. and why. Some of them are natural. If you are an exporter, you have a natural hedge: Borrowing in U.S. dollars when you have revenues in U.S. dollars makes sense.
However, are there cases where people are not borrowing in Canada because of some kind of problem with our markets, a regulatory problem, or the participants in the markets have not developed sufficient expertise? I will give you an example. For a long time the Government of Canada was the major borrower in Canadian markets. That pushed many other borrowers outside the markets; there just was no room for them. One of the beneficial results of having our budget deficits under control is that much of the borrowing that used to be done outside the country can come back. Corporate borrowing and provincial borrowing are coming back into the country. This is what economists call ``crowding in'' as opposed to crowding out.
Looking at data, what proportion of Canadian shares is inter-listed? Of those inter-listed shares, what proportion is being traded in American as opposed to Canadian markets? Just getting the facts can be very helpful in looking forward.
To the extent there are impediments to the growth and good health of the Canadian market, for whatever reason, those are artificial kinds of things that we should work hard at trying to eradicate. Of course, that is what that Wise Person's Committee — I think it is called — is doing.
As we move forward, it is hoped that we can work to get rid of some of the costs of operating in Canadian financial markets. Of course, the more efficient those markets, the less costly it is for Canadian borrowers to use them and therefore the more likely those markets are to flourish.
The Chairman: On Sunday, there was an article in The New York Times written by Niall Ferguson, professor at the Stern School of Business, New York University, and a senior research fellow at Oxford, discussing the huge debt that the United States is accruing as a result of its current fiscal policy — cutting taxes, the war, et cetera. Mr. Ferguson says that foreign investors have claims amounting to $8 trillion of its financial assets as a result of the increasing American balance of payments deficit, which total near $3 trillion. He believes that it is not impossible to imagine that if all those foreign holders of bonds worry about the Bush administration's combination of increased military spending and decreased taxation, there could be a real crisis in the United States.
Also, there is apparently quite a bit of worry about Japan, where a financial crisis has already started.
The question is, for a country such as Canada whose biggest trading partner is the United States, what kind of an effect on our economy would you see as a result of such as a crisis of confidence in the American dollar? I think you alluded to it once before in one of your appearances here.
Mr. Dodge: There is a relatively large build-up of liquid claims on the United States. We have seen, for example, large increases in the reserves, particularly of Asian countries and China, as it has tried to stabilize its currency against the U.S. dollar. That is one set of issues — and one that is always there if, indeed, foreigners lose confidence in the U.S. dollar.
Over time, it is clear that the largest and most advanced economy in the world really cannot continue to run up claims on the order of 4 per cent or 5 per cent of GDP year after year on the world. There are economic forces that will bring about some redress of that situation. We are seeing some of it right now as we see the U.S. dollar depreciate against a number of other currencies, which will tend to begin to bring that back in line. The other thing that is important is the confidence in the European economy and the Japanese economy must be restored so that we get a more balanced flow of capital around the world.
Is there a risk of a financial crisis? I believe the risks in the United States are indeed very low. The United States banking system is healthy. The United States corporate sector is financially relatively healthy — not quite as healthy as it was a couple of years ago, nevertheless relatively healthy. The risks of that sort of crisis occurring in the United States are relatively low but, as we talked about 18 months ago in this committee, there will have to be a bit of a rebalancing.
Let me ask Mr. Duguay, who watches these things, to say a few words on that.
Mr. Pierre Duguay, Deputy Governor, Bank of Canada: I should like to make two points. First, when you look at overall savings, the current increase in government deficit and government debt is partly cyclical because of some of the weakness of business investment. Clearly, it does set up some adjustment that will have to be made in public finances down the road; but adjustments like that are not necessarily a crisis. When they do occur, they also occur at the same time that there are parallel adjustments taking place, so presumably we would see more business investment at the time. That is also true for the world as a whole in terms of the current account imbalance.
It does reflect the fact that domestic demand is strong in the United States — stronger than it is in Japan and in Europe. Therefore, when there is some reduction of inflows of capital into the United States it is probably because there is increased domestic demand abroad. There may be a need for some adjustment of U.S. interest at that point — some risk premiums — but when it does happen, the exchange rate would offset part of this adjustment. You would have some increase in domestic savings in the U.S. because the U.S. has to start reducing their indebtedness, but that would be offset by a reduction of the current account balance so that the economy continues to grow at a steady pace.
Senator Tkachuk: Governor, while most people who look at the budget numbers tend to focus on whether the government expects to run a surplus or a deficit, those who manage the government's cash flow must focus on financial requirements. In February, the Minister of Finance told us that on an accounting basis he would have a balanced budget this year and next. He also predicted that there would be net financial requirements of $5.8 billion this year and $2.1 billion next year — in other words, over two years the government will face a $7.9-billion cash shortfall.
This, of course, does not reflect foreign exchange operations. If you decide that the dollar is rising too fast you can slow it down by selling Canadian dollars, which would increase the government's financial requirements even further.
Do you see foreign exchange operations over the next year as adding to the financial requirements, or do you see it as adding to the cash flow, in other words, if you had to do the reverse?
Mr. Dodge: As you know, senator, we do not intervene in financial markets in the foreign exchange market. We believe that the markets operate relatively efficiently and since we stopped intervening in 1998 that has been borne out. Therefore, we do not foresee a change in our policy. We have run it for almost five years now and it seems to have worked relatively well.
Senator Tkachuk: The government expects to meet its projected financial requirements without taking on any more market debt. At the end of February, the government's cash balance was $5.9 billion, as it approached the fiscal year where the financial requirements, excluding exchange operations, are projected to be $5.8 billion, to be followed by a second year where the requirements are $2.1 billion. It is tight; and indeed is minus $2 billion over two years, assuming that March is awash.
Have you and the Minister of Finance at any time discussed the possibility that the bank's foreign exchange operations, combined with the government's other financial requirements, would force the government to take on new market debt?
Mr. Dodge: No. We have a very clear policy with respect to the exchange fund account, which we manage on behalf of the government. Our policy on that account has been to get to a position where the government's U.S. dollar borrowings are equal to the amount that we have in the account. That is what we have been doing over the past little while to try to bring those two things into alignment. Otherwise, we anticipate no changes.
Senator Tkachuk: Nine years ago, The Globe and Mail — I think September 2, 1993 — reported the following:
A Liberal government would tell Bank of Canada Governor John Crow to pay greater attention to job creation and not be fixated on inflation, Liberal Leader Jean Chrétien said yesterday. ...
Asked what he would do if Mr. Crow disagreed with Liberal priorities on job creation, Mr. Chrétien replied, ``I am telling you that he's an official of the government.''
Of course your predecessor, Mr. Thiessen, at appearances before the committee, repeatedly assured us that beyond his normal ongoing discussions with the Minister of Finance there had not been an attempt to direct the bank's conduct of monetary policy.
In your particular case — you have been governor for two years now — is the government telling you what to do?
Mr. Dodge: No.
Senator Prud'homme: You do not need to answer that.
Senator Tkachuk: It is a fair enough question, considering Mr. Crow's book.
Mr. Dodge: It is a fair question. The act requires the Minister of Finance and myself to consult regularly and that is what we do.
As you know, in response to the Enron and WorldCom situations the United States brought in the Sarbanes-Oxley Act. As the chairman mentioned, we had a session with Mr. Greenspan. In speeches he made prior to July, when it came in, he was not in favour of that sort of approach. His was a more principle-biased as opposed to our legal, law- based way of regulating the securities industry. Yet he says that we have this now and it will be there for the next round of greed to deal with those situations.
Do you have any feeling as to whether or not this committee should be recommending that we come in with similar legislation?
Mr. Dodge: Senator, clearly that is not our province at the Bank of Canada. Let me make a couple of comments that may be helpful.
First, on reading Sarbanes-Oxley — whatever you think of the details of that bill — the basic principles and what they are trying to achieve are indeed very laudable. The principles embodied in that act are important principles. They are ones that I think all participants in Canadian financial markets would largely subscribe to.
Second, it is important that Canadian issuers have access to U.S.-capital markets. Hence, it is quite important that Canadian issuers in Canada be seen abroad to be abiding by the same general principles that are set out in Sarbanes- Oxley. Whether or not in detail we need to do exactly the same thing, I have a hard time commenting on that. In detail, we now have the advantage of having seen the fallout of that for a while. We may be able to make some improvements.
In principle, since we live in North America and since New York continues to be the major source of foreign capital for our firms, we have to be roughly in line. I do not see any real advantage to being out of line, in principle.
In regard to the details, I am really not the right person to ask.
Senator Moore: I know you are not a securities regulator, but neither is Mr. Greenspan and he had an opinion.
Do you think we should have a single national securities regulator?
Mr. Dodge: However we accomplish the process, we must try to reduce the cost to Canadian issuers. There are a number of ways to achieve that.
Senator Moore: Every province and territory has its own commission; is that not correct?
Mr. Dodge: That is correct. There are a number of ways of achieving a reduction in the cost of issuance in Canada. One would be to have a single regulator; a second would be to have uniform securities rules in all provinces; a third would be to have close to uniform rules, but every province accepts that a filing in one province would be acceptable for them. There are a number of ways to achieve the goal. We are not there at the moment. I do not think one ought to be fixated on a mechanism, but the issue is important, and that is to reduce the cost of issuance for Canadian issuers.
Senator Moore: You did not answer my question. Clearly, it would be more cost-efficient to have one regulator and it would probably make, in this case, our North American neighbour feel a little better if we had one.
Mr. Dodge: After all, the Americans do not have one regulator, either. I am not absolutely sure that a single commission is necessarily the answer.
Senator Moore: As long as they all have similar principles and they respect the filing and will honour each other's filings.
Mr. Dodge: An issuer should be able to file once and be done with it.
Senator Angus: I am informed today that the U.S. dollar hit a four-year low vis-à-vis the euro and that the Canadian dollar hit a three-year high vis-à-vis the U.S. dollar, up to $69.83 I believe. Is this significant? What does it indicate to you other than a weakening U.S. dollar and a strengthening Canadian dollar?
Mr. Dodge: Words convey different meanings. We are back to where we were three years ago in terms of our bilateral exchange rate with the United States.
For the reasons we discussed earlier in answering the chairman's question, part of the process of rebalancing in the U.S. is that we have had better economic performance relative to the United States. In those circumstances, an exchange rate — which is a price like any other price — is doing its job in terms of sending appropriate signals to Canadians and Americans as to how to conduct their affairs.
Our view is that for Canada —and, indeed, probably for most developed relatively small open economies — an arrangement of a floating exchange rate and a monetary policy based on some form of inflation targeting certainly seems to yield, for all of our individual economies, the best performance in terms of stability and in terms of long-run economic growth.
Mr. Freedman: This is only partly facetious; but in New York and London 10 or 12 years ago, there were big turnouts for these discussions because they wanted to know what in the world was going in Canada — we had so many fiscal, monetary and problems and the like. Then there was a period a few years ago where we were not getting any kind of turnout at all because nothing was happening.
More recently, at the governor's appearances in Britain and Italy there was a significant amount of interest in Canada. We are the only G-7 country with a budgetary surplus. Our debt-to-GDP ratio is going down, both domestically and externally; we have more than 500,000 jobs. People are wondering how we are doing this.
Senator Prud'homme: Maybe they should not know.
Mr. Freedman: I am perfectly happy to tell them what we think we have done. It is much more fun now than it was 10 years ago for us.
More substantively in to your question, obviously, the exchange rate movement does have an effect on our thinking. When we look forward 18 to 24 months, we ask what is likely to happen to the Canadian economy, domestic demands, external demands — everything that affects those demands and hence will affect the balance between supply and demand inflation is factored in when we make our decisions. Information on demand related to the fiscal policy, consumer expenditures, business confidence and the exchange rate, along with everything else happening abroad — in particular the strength of the U.S. economy, which is the most important factor — feeds into our thinking as to what is likely to happen. Obviously, as our staff does that kind of assessment of what demand is likely to be through 2003 and 2004, we are looking at what is happening in Europe, Asia, and the U.S. Part of that does take account of exchange rate because that is a factor that affects foreign demand for Canadian goods and services.
Senator Angus: It is interesting that you emphasized how important a strong U.S. economy is to us. We have had many exchanges, year after year, with folks from the bank about the extent to which we are basically in lockstep with our good friends to the south.
I watched the Federal Reserve chairman this morning as he said basically that he is not sure but there are signs. The reality is that there is a gap of about 200 basis points between our rate and the U.S. rate, on the overnight, at least. That may increase on May 6, I am told, depending on what they do. There does seem to be some concern in the U.S. about the slowness of the recovery.
I have a question about the spread and the level that it is at. What would the Bank of Canada consider to be an acceptable upper limit on the gap between the U.S. and Canadian rates?
Mr. Dodge: I do not think there is a number because it depends on the relative situation in both countries. There is no specific answer to that question.
Senator Angus: I am pleased to hear that because some people do wonder, for example, about the Bank of Canada raising rates in these circumstances. There are many reasons that you take into account when you raise our rate. I believe we are up to 3.25 per cent and that increases the spread. Some cynics say that was done because there was so much disaffection with our 62-cent dollar. I know there are many people in this country who do like a low Canadian dollar, but some say the Bank of Canada is consciously increasing the spread to strengthen the dollar. Others say that the Governor of the Bank of Canada does not want the dollar to go above 70 cents. There are other reasons.
I realize it is tricky for you but can you demystify that particular subject?
Mr. Dodge: Let me return to the answer that Mr. Freedman gave to your previous question because that is the essence of the issue. What we are trying to do with monetary policy is to ensure, over time, that the Canadian economy operates as closely as possible to its potential. We do not want to get way over potential for a period of time and hence see a big run-up in prices; nor do we want to see a big dip below potential.
That is our goal. Over long periods of time, that plan will yield the highest average growth rate as well, which is our real objective.
Senator Angus: That gives low inflation and steady incremental GDP growth?
Mr. Dodge: That produces higher real incomes for Canadians. We discovered in the 1970s and 1980s, much to our pain, that when inflation gets very volatile we must move in a more volatile way to deal with it. That is not helpful to long-term growth. Indeed, we end with bigger cycles.
We are trying, as best we can, to stay on that path so that we are always headed, over the next 18 to 24 months, to be just at that ``Goldilocks'' point, where the economy is neither too hot nor too cold.
Senator Angus: If our dollar were at par with the U.S., you would be comfortable?
Mr. Dodge: We look at the totality of circumstances. Clearly, if world demand for our products is very strong and if we have very high prices for the goods and services that we sell to the world, then one would expect in those circumstances to see a stronger Canadian dollar. Similarly, as we just mentioned, there was the Asian crisis of 1997, followed by the Russian crisis, then the commodities prices — of which we sell a lot — fell out of bed, and then the Canadian dollar depreciated. That response was absolutely appropriate in those circumstances. We were trying to hold interest rates down so that we would not dip way below potential.
We look at the totality of those things. We have one instrument within our control and that is monetary policy. We operate that through the overnight rate, but it is the totality that we really are worried about.
Mr. Freedman: Senator, you said something about being lockstep with the U.S. I am sure you did not mean it in a kind of literal sense. However, over the last four or five years, it has been shown that our economy does not necessarily move in lockstep with the U.S. Obviously the U.S. is extremely important. Of the 40 per cent of our GDP that is exported, about 85 per cent or 87 per cent goes to the United States. It has to be important.
On the other hand, when the U.S. economy weakened, our economy continued reasonably well and out-performed the U.S. That is quite different from what we remember from 10 years ago when, if the U.S. economy sneezed the Canadian economy was said to have pneumonia.
That did not happen in this case. Domestic demand in Canada remained strong in spite of a weakening in the U.S. Does that mean the U.S. economy does not affect us? Of course, it affects us, but as the governor said, we look at everything that affects us. Our domestic demands in Canada were able to remain fairly strong right through the piece and that obviously helped us a great deal.
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Senator Hervieux-Payette: Governor Dodge, my question relates to something you said in your opening statement, namely that the rise in interest rates can be attributed to the fact that the CPI inflation rate peaked at 4.6 per cent in February. What relative weight would you give to each component mentioned, that is oil and natural gas prices, insurance premiums, housing and other services?
I realize that the Consumer Price Index is comprised of a number of components. Is oil the most important one? With respect to insurance premiums, if rates fall the next month, does this automatically result in a drop in the CPI? A number of reasons can be given to explain rising premiums. Companies are not earning the revenues to offset losses incurred. Obviously, these days, the stock market is not performing that well.
Are we destined to witness the same phenomenon each month? Or, are oil and gas prices such leading indicators that we are likely to see the CPI fall to a more reasonable level in the months ahead?
Mr. Duguay: That is a complex question, one that requires a detailed response. If you look at the CPI, you will not that the CPI inflation rate peaked at 4.6 per cent in February, which is higher than in February of last year. If you look at the core CPI, and exclude volatile energy components such as natural gas, heating oil, gasoline, as well as components like fresh food products and tobacco taxes, you will see that the core CPI rose 3.1 per cent, an increase just slightly above our target band, and then fell to 2.9 per cent in March.
The spread between 3.1 per cent and 4.6 per cent largely reflects the effect you noted of energy prices and also reflects fourth tenths of the increase in the tobacco tax. Therefore, a full percentage point or more of this increase can be attributed to the energy component.
The core CPI of 3.1 per cent is affected by a number of one-time, special factors. You mentioned higher insurance premiums, primarily automobile and home insurance premiums.
This adds a certain element of volatility to the figures. In the case of automobile insurance, premiums have increased fairly quickly.
Over time, and during the last three or four years alone, insurance companies have been making fairly substantial profits, earning high returns on their market investments and managing to absorb higher benefit without having to resort to increasing their premiums.
Obviously, with the downturn in the market, premiums must be increased to match benefits paid out. What we are seeing now is the industry adjusting to the situation. This adjustment has meant an average increase nationwide of 30 per cent in automobile insurance costs. Some regions of the country, for instance Atlantic Canada, have been hit with much higher increases. However, nationwide, the increase over last year is 30 per cent. This alone likely accounts for a rise of 1.2 per cent in the core CPI.
If we exclude this component, inflation is running at just under 2 per cent. That is not excessive. As such, the calculations are false. Admittedly, we want to avoid extremes. However, it would be unreasonable to expect no increase whatsoever in insurance premiums.
If we look at the trend and acknowledge that the increase in the CPI would have been more in the normal range had there not been a long period of stability followed by a sudden catch-up spike, we would ultimately have seen a slightly higher inflation rate over the past several years, slightly under the current level of 3.1 per cent, and likely somewhere between 2 per cent and 2.5 per cent.
We take this as a sign that the Canadian economy is recovering somewhat. There is some upward pressure on demand and we are quickly reaching our production capacity. The Bank did not hike its interest rate merely because overall inflation was running at 4. 6 per cent. Rates rose much more because of inflationary trends. Inflation is extremely volatile.
If we consider inflation trends, we note that inflation has been slightly above our 2 per cent target. As mentioned, we are experiencing some pressure on the demand side in the housing and services sectors.
Senator Hervieux-Payette: What type of services would these be?
Mr. Duguay: Recreational services, services in general or personal services. Inflation is not excessive, but there is some upward pressure. That should come as no surprise because as was mentioned earlier, the Canadian economy is doing well because of very strong domestic consumer demand, particularly in the housing sector.
These pressures are an indication to us that the Canadian economy is operating fairly close to its full production capacity. This observation is confirmed by a number of other measures and by the information coming in to our regional offices further to some business surveys. For this reason, we have reduced monetary stimulus within the system to some degree.
As far as inflation goes, the last point I would mention is price volatility, as the Governor mentioned in his opening remarks. Energy prices rose sharply, particularly during the first quarter when compared to the same period last year. However, natural gas and oil price have already begun to decline. We expect that when this year's prices for January, February and March are compared with prices for the same period last year, we will see a drop in prices and a lower overall CPI than our trend index. That is one of the reasons why we tend to exclude energy price volatility when setting monetary policy.
Mr. Freedman: More important, if one-time factors were all we had to contend with, that would not pose a problem or be cause for concern. However, with some broadening of price pressure and increased inflationary expectations, the result can be higher interest rates. If you look at our press releases from late last year, you will see that we discussed these one-time factors. It was not until we learned in January that inflation would be broader in scope that we began to advise the Canadian public of this pressure. After that, we increased interest rates twice.
Senator Biron: In the early 1990s, in an effort to fight inflation, the Bank of Canada increased interest rates. This increase far exceeded the 300 basis points in the United States. Manufacturers, who generally hold 50 per cent equity, were not happy to see their lending costs rise to a level much higher than in the United States. This meant they had to charge more for their products.
Moreover, since the prime rate was much higher, this created a demand for the Canadian dollar which consequently, almost achieved parity with the U.S. dollar. In light of this fact, and the fact that U.S. productivity levels were higher than Canadian levels, U.S. exporters could export their products to Canada at a cost such that Canadian manufacturers were not able to compete. The end result of all this was the recession that followed after 1990.
Prior to 1990, 300 basis points was viewed as the maximum acceptable limit. Interest rates in both countries had never exceeded this limit, not until the early 1990s when the target level was finally surpassed.
Will you endeavour to maintain a prime rate of no more than 300 basis points and will you remain hopeful that the Canadian dollar will rally as a result of a more optimistic GNP-to-debt ratio?
Mr. Dodge: You have rolled several questions into one. I will let Mr. Freedman answer your question concerning the monetary policy in place in the 1980s and early 1990s, since I was not with the Bank at that time.
We have managed to convince Canadians that we will keep interest rates in the 2 per cent range. This is a critical economic capital consideration. In fact, the outlook continues to be optimistic. Even though oil prices continue to rise, expectations for the long-term are that the inflation rate will remain steady at around 2 per cent.
Therefore, we are not facing the same kind of challenge that the bank faced in 1989 and 1990, namely that of having to change Canadians' expectations. We already have this trading capital and now we need to maintain it. That is precisely what we are trying to do. Our job this year is much simpler than it was fifteen years ago.
The U.S. is grappling with an economy that has been performing poorly. Short-term interest rates are almost the lowest they have ever been, particular since World War II.
It is important that the U.S. conducts its monetary policy in a way that is appropriate to its own situation. It is in Canada's interest to see the U.S. economy perform better.
It comes as no surprise to see a spread of this magnitude in short-term interest rates. It is interesting to watch the situation unfold because 30 years ago, the spread was nearly 50 basis points, which was considered normal, more or less. Long-term interest rates in Canada are slightly higher than in the United States. The spread is relatively small. This is a good indication that we have succeeded in creating expectations. However, the Bank was facing a real challenge in 1990.
Mr. Freedman: It all depends on the circumstances. The situation was totally different in the late 1980s. Inflation rates were higher in Canada. The economy was also experiencing upward pressure in terms of capacity. The Bank stepped in to increase interest rates. Typically, when interest rates rise, currency values should rise as well. The Canadian economy was affected by these moves. It weakened somewhat and the inflation rate fell fairly quickly, more quickly than we had anticipated, or had planned for.
Today, we are facing an entirely different situation where our economy is continuing to perform strongly vis-à-vis the U.S. economy. Admittedly, there is upward pressure on inflation rates, but the situation is very different from what we were experiencing a decade ago. It is important to note that we do not have a target in mind in terms of the spread between Canadian and U.S. interest rates. The latter are set as a result of respective national monetary policies appropriate to each country's central bank. If the economies of the two countries are performing differently, then we are likely to see a spread in interest rates. However, we are not saying that the goal is to have a spread of 300 basis points. One must remember that in 1997 and 1998, Canadian interest rates were much lower than U.S. interest rates. That was the first time since the war that this had been the case, owing to the fact that the Canadian economy was much weaker than its U.S. counterpart. It was appropriate at the time that the situation should be thus. Today, with the Canadian economy outperforming its U.S. counterpart, the situation is reversed. We never set a target in terms of the spread between Canadian and U.S. rates.
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Senator Angus: Governor, in the wake of the near meltdown of the Japanese, banking system and so forth, there were writings about the risk of deflation in the U.S. at the same time as we were more concerned about inflation in Canada.
It seems to me that there is something here that is quite important. Is there a real risk of deflation in the U.S., and if so, what would the impact be on us?
Mr. Dodge: In all countries, including are own, we are seeing that goods prices have either been falling or rising very slowly, largely because we have had major improvements in productivity in goods producing industries and also because we have more competition in those industries — that competition now coming from China and other Asian countries. What we have seen, therefore, is, quite appropriately, goods prices move down and we are having real income gains because of that.
On the other hand, service prices and services constitute somewhere between two-thirds and three-quarters of our economy. Service prices in all countries, including Canada, continue to rise, and, indeed, in the United States they continue to rise at a pretty significant rate.
There are two exceptions. One is Japan, where service prices have not moved down as much as goods prices, but nevertheless have been rising very slowly. The second is Hong Kong, where we have had a major deflation underway because the Hong Kong currency, as you well know, is pegged to the U.S. dollar, and it is the only way they can adjust.
Is there a risk of deflation in terms of generalized price decreases in the U.S. across the whole spectrum? I think that risk is very low.
Is there a risk of deflation, such as in the 1930s, where we have huge output gaps open up and massive unemployment? I think that risk is extraordinarily low because we have learned a lot in the interim and policy can counteract that.
Senator Kroft: My question is still on exchange and interest rates. In your report you conclude, in the very last paragraph, by suggesting that there will be some reduction in monetary stimulus, which we understand to mean some rise in interest rates. The fourth paragraph on page 2 contains a number of assumptions — that oil prices are where they are and that the Canadian dollar stays close to current levels. Just so that I understand it, do you see that there is room for this relative upward movement on interest rates vis-à-vis the U.S. without it affecting the current exchange level? That is what I read when I put these two paragraphs together.
Mr. Dodge: I did not intend that to be read in that way, senator. In the paragraph on oil, I am simply saying that in order to understand the impact — and following up on Senator Hervieux-Payette's question and Mr. Duguay's response — in assessing the impact of oil price movements, one must translate that back into Canadian dollars. Therefore, we made that assumption here in order to evaluate the impact of the oil price on the CPI.
That is what that is all about. Obviously, at 69 cents, the actual price of petroleum in Canadian dollars has fallen faster than it has in U.S. dollars.
The Chairman: Gentlemen, thank you very much for your time. This has been very informative. We look forward to seeing you again in the future.
Mr. Dodge: We should give the last word to Mr. Freedman since this is the last time you will hear from him in his professional capacity.
Mr. Freedman: It has been a pleasure appearing before the Senate, both meeting individually with some senators as well as with the group.
I would make one comment in light of this expected movement of interest rates. Gordon Thiessen had a wonderful line. He used to say, ``We are not putting our foot on the brake; we are taking our foot off the accelerator.'' That is well worth remembering.
The committee adjourned.