Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 1 - Evidence - Meeting of May 3, 2006
OTTAWA, Wednesday, May 3, 2006
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:05 p.m. to examine and report upon the present state of the domestic and international financial system.
Senator Jerahmiel S. Grafstein (Chairman) in the chair.
[English]
The Chairman: This is our first formal meeting in this new session of Parliament. We are absolutely delighted to welcome the new and old members of the committee, including my deputy chair, Senator Angus. Of course, we are delighted to welcome once again David Dodge, the Governor of the Bank of Canada, who comes to this committee twice a year to give us his overview pursuant to the mandate in the Bank of Canada Act under which he serves.
Governor, this hearing, as you know, is being televised from coast to coast to coast and via the Internet around the globe. People are breathlessly awaiting everything you have to say. From time to time, our website flashes across the screen, and we welcome comments or questions from our Canadian public.
This committee wants the Canadian public to participate. That is why we intend to televise as many hearings as possible, as close to live as possible. We want the Canadian public to feel that they are part of our proceedings. We are here in Ottawa not just to opine. We are here to listen to you and to listen to what the Canadian public has to say about our deliberations.
Governor, welcome. Perhaps you might introduce your colleague.
After the governor speaks, senators will follow our normal practice, and our august deputy chairman will lead with the first questions.
David A. Dodge, Governor of the Bank of Canada: Thank you very much, Mr. Chairman, and members of the committee. Paul Jenkins and I really appreciate the opportunity to meet with this committee twice a year following the release of our Monetary Policy Report.
As you said, these meetings help us keep senators informed and, through you, all Canadians, about the bank's views on the economy and about the objective of monetary policy and the actions we take to achieve it.
When Mr. Jenkins and I appeared before this committee last October, we said that the global and Canadian economies were continuing to grow at a solid pace, that our economy appeared to be operating at full production capacity, and that it would remain at about capacity throughout 2006-07.
At that time, total and core inflation were projected to average close to 2 per cent, beginning in the second half of this year. This projection, I would remind you, assumed oil prices at roughly US $64 a barrel, a level then indicated by futures prices. Our projection at that time also assumed stable commodity prices, government spending that would grow roughly in line with revenues and a Canadian dollar continuing to trade in a range of 85 to 87 cents.
I have gone through this history for the benefit of the new members of your committee, to remind you where we were last fall when we met with you.
Last Thursday, we released our April monetary policy report, copies of which you have.
[Translation]
In our April Monetary Policy Report, we say that the global economy has shown a little more momentum than had been anticipated: oil prices have been roughly US $10 per barrel higher than last October; metals prices have risen significantly since October; and the Canadian dollar had been trading in a range of 85 1/2 to 88 1/2 cents US.
In our Report, the Bank projects economic growth of 3.1 per cent in 2006, 3.0 per cent in 2007, and 2.9 per cent in 2008. Total CPI inflation will continue to be volatile and affected by developments in the markets for crude oil and natural gas, and will average close to 2 per cent in 2007 and 2008 (excluding the effect of any changes in the GST). Core inflation is projected to rise to 2 per cent in the second half of this year and remain there through to the end of 2008.
[English]
This projection is based on three key assumptions: first, that energy prices will remain roughly as indicated by futures prices over the period to 2008; second, that Canadian governments will continue to run budgets that are roughly in balance over that period; and third, and very important, that the orderly resolution of global imbalances will evolve, and that it will involve a gradual depreciation of the United States real, effective exchange rate.
Also important, we assumed that only a small fraction of this depreciation will be against the Canadian dollar and that depreciation will occur late in the projection.
The projections in the report are based on those assumptions.
It is very important to note that there are upside and downside risks to that projection for growth and for inflation. We judge that these risks are roughly balanced in the near term, with a small tilt to the downside later in the projection period. That tilt relates to the possible disorderly correction of global imbalances.
We consider this risk to be slightly smaller than when we met with you in the fall, given the tentative signs of policy adjustments in some countries and given the rotation of global demand.
In line with the bank's outlook for the Canadian economy and our current assessment of risks, some modest further increase in the policy interest rate may be required to keep aggregate supply and demand in balance and inflation on target over the medium term. We will closely monitor evolving economic developments in the Canadian economy in light of the cumulative increase in the policy interest rate since last September.
Mr. Chairman, in closing, I want to emphasize that what we lay out here in our April monetary policy report is a projection for growth and inflation. The projection is based on the assumptions that I have just noted. We publish this projection so that all Canadians and financial markets know the basis on which we will judge economic developments in the future.
I want to emphasize that when we set our policy interest rate eight times a year — the next two occasions will be May 24 and mid-July — we assess all available information on the global and Canadian economies relative to our base-case projection and the assumptions underlying that projection. Then we make our monetary policy decisions.
I think, Mr. Chairman, that is enough from me. Now Mr. Jenkins and I will be happy to answer your questions.
The Chairman: Thank you, governor. Thank you, Mr. Jenkins. I want to tell you that the committee is primed for questions. Before I turn to our deputy chair to lead the questions, I want to congratulate him on his influence with his government. One of the key recommendations in a study by the committee had nothing to do with this hearing but rather pertained to your attitude toward policy. It is the budgetary item that allows charitable deductions to be received by stock to public foundations, which was almost two-thirds of the recommendations of this committee. I congratulate the deputy chairman who, I am sure, was most influential with his minister then, now the Minister of Finance.
Senator Angus: Welcome governor and deputy governor. It is a particular pleasure for me, after 13 years on this committee, to address my questions to the Bank of Canada officials as a supporter of the incumbent government, following the events of January 23, 2006.
Many things are happening out there to cause Canadians to focus on matters of great concern to the Bank of Canada. When Senator Grafstein indicated that many Canadians are waiting with bated breath to hear what you have to say, I can only refer you to the perils of being the governor as reported in this morning's National Post. It indicated that the lesson for central bankers is that they should never go to parties. When you folks talk, the markets listen and are thus affected. We know that your words to this committee and to Canadians listening will be measured, as they always are. I add my word to that of the chairman's word that Canadians should listen to what you have to say.
I know that average Canadians, not sophisticated economists or theorists, are deeply concerned about the present level of the Canadian dollar vis-a-vis the U.S. dollar, and the present cost of gas at the pumps, more than $1.03 per litre. These facts are on the tips of tongues of all Canadians, who wonder what you think about the current figures and how they affect your view of the world. Conservative senators will have many questions about those specifics, and I would like your comments on how the price of gas and level of the dollar affect your policy-making. As well, can you comment on one of the fundamentals that you folks always refer to — the Canadian economy and how it is functioning?
In one of your recent reports, you used the phrase, It is functioning at full or even slightly beyond full capacity. I do not pretend to be a sophisticated economist and so I wonder where the limit is. What is beyond full capacity? If Tory times are good times, as I believe, and the economy will continue forward, what happens when you reach a certain point? What number is beyond full capacity?
Mr. Dodge: There are three questions — oil, the Canadian dollar and what we mean by capacity. Those important issues underlie our outlook and affect our decision-making process. Perhaps I could treat this as three different questions, Mr. Chairman, because they all go to the heart of our monetary policy and the heart of what is in the report.
On the first question with respect to crude oil and petroleum products, we are not experts. That is why we have decided that the best thing we can do, in terms of our outlook for prices, is to take the futures curve. I will tell you what I think is affecting that curve and why it is up there at the moment.
Globally, for four years, including 2006, we have had 4-per-cent-plus real growth in the world. We have not had that at any time since the Second World War. It has meant that the demand for energy, in particular the demand for petroleum, has been increasing sharply. The most rapidly growing emergent economies, China and India, at the margin are huge consumers of oil and gas. That is the source of their marginal energy source. It is not surprising that with this rapid growth in demand for oil from these newly emerging economies plus a strong recovery in the United States, which is the world's largest consumer of oil, that demand over the last four years has clearly outstripped the growth of production capacity. At this time, the rise in oil prices is driven very much by a growth in demand.
This rise is different than the experience we had in the 1970s when a supply restriction bumped the prices up. That is point number one.
Around the world, national oil companies and the big internationals are struggling to increase capacity but that is not easy to do quickly, even for the easily accessed oil in Saudi Arabia. While new production will come online over time, we have hit a capacity constraint because world growth has been so rapid, essentially; and that has driven oil prices up. We are so close to capacity that if anything happens around the world, some capacity can go offline. Hence, a risk premium is built into the current market price. From week to week, those futures prices move around as geopolitical events indicate a greater or lesser probability that production somewhere around the world will go offline.
This rise is market driven and so, in the short term, there is little that any government in the world can do about it. For now, we will have to get used to living with higher petroleum prices, which will, over the medium term, draw out more petroleum production that will tend to draw down the real price. As well, high prices will influence the growth pattern of consumption, hence bringing supply and demand into balance once again. The best thing we can do is take the futures curve. We do not think there is anything fundamentally screwy about the pricing against that futures curve.
Senator, your second question is on the strength of the Canadian dollar, and I will take that before I turn to Mr. Jenkins to speak to the third question on capacity. We enumerated these three issues so I am glad you raised them.
Senator Angus: In respect of the price of petroleum, I am not sure that this is relevant. With the Standing Committee on Energy, the Environment and Natural Resources, I was privileged to visit the Organization of the Petroleum Exporting Countries, OPEC, in Vienna last September, where we were given a fulsome and welcoming reception.
At that time, we had been paying in a $70 to $75 range. The members of OPEC said they saw the price coming back to, and settling around, $60, but that their concern was not the supply and we should not be concerned about supply from OPEC and the major exporting countries. Their concern was of demand.
It is interesting in that context. Does that influence at all what you have to say?
Mr. Dodge: I am not at all surprised they said that to you. They are concerned, as are Canadian oil companies developing our own resources, that at some point we could have a sharp downturn in prices, which would take those prices well below what was necessary to recover the costs of developing the higher-cost sources of oil. That is always the concern of a producer in any commodity market, be it oil, metals or food; that is the major problem.
Of course, they would like some stabilization guarantee that we would keep the price above some level in the future. Such guarantees are difficult to give and, indeed, we have learned by bitter experience in all sorts of commodities that often that guarantee does not help very much.
The Chairman: Governor, I want to raise this with you and all the senators. I have a full number of questioners, and I am looking at the clock. We have an hour and a half before we have to end this hearing because of the space limitations.
I was more generous with the deputy chairman because I know he would lead on substantive questions. I hope other senators will limit themselves to three or four minutes; and your answers, if you do not mind, could be more precise. These measures will give us an opportunity for a greater exchange, which we are trying to develop here, as opposed to speaking blind to one another.
We will start on the Liberal side, with the august Liberal senator from British Columbia, Senator Fitzpatrick.
Senator Fitzpatrick: Thank you and welcome, Mr. Dodge and Mr. Jenkins. Thank you for your usual clear presentation of the monetary situation. You have a complicated and large job.
It seems more difficult at the present time — and I heard what you said about the futures — as you have a divergence of these factors coming together, which will have a cumulative effect as to how you deal with them.
Obviously, you cannot give us predictions on what will happen to the interest rates. However, if these factors — with the higher price of oil and the exchange rate between Canada and the United States — have the same kind of impact that increasing the interest rate would have, I guess the other curious part with respect to the exchange rate is this. The prices of retail goods have not come down yet, as one might expect. I know there is a time period for this to take place. However, the prices have not lowered even though our Canadian dollar has strengthened.
Can you give us an assessment, with the fact that these things are coming together at this time, of how much more difficult that is making things for you?
Mr. Dodge: In many ways, the question is an amplification of Senator Angus's second question. It points out precisely the difficulties we have.
First, Canada has benefited since 2003 from an improvement in trade. That improvement has increased our incomes and the demand for Canadian goods abroad, and certainly has increased the prices we get for those in aggregate.
That increase has pushed up the normal way the markets work, and the value of the Canadian dollar. Last January we set out, in the Monetary Policy Report, a box on how we look at it. Those real market forces that are out there operating, we call ``type one'' forces. The Canadian dollar clearly adjusts up in response to those strong factors, just as it adjusted down after the collapse of commodity prices in the late 1990s. That is a primary thing.
We have also identified what we call ``type two'' factors, which are those unrelated to our position here in Canada but very much related to what is going on in the world elsewhere. How we deal with those issues in terms of monetary policy is different because the type-one adjustment, the real adjustment, is part of what ought to go on in the market, and we do not have to make compensation in monetary policy for that. The type-two adjustment is quite different, and we would want to gauge our monetary policy carefully in reaction to that.
We have said, certainly until early this year, that by and large much of the adjustment in the Canadian dollar was a result of these market forces. Clearly, though, every time we sit down and make a monetary policy decision, we make a judgment as to what is happening. When we come to May 24 and to mid-July, we will look at that and make a judgment as to what has transpired over that period in the Canadian dollar, and how that really ought to affect our policies.
While the Canadian dollar exchange rate is only one of a number of factors that influence what we do, clearly it is one. All Canadians should understand that we do take that into account.
Perhaps I could ask Mr. Jenkins to say a few words on some of the other pieces in here, because you asked about the impact of the Canadian dollar on the price of imported goods and services here in Canada.
Mr. Jenkins: Thank you, governor. Let me add a few comments in that regard.
First, the strength of the Canadian dollar provides an offset to the U.S. dollar increase in many commodities, as you suggest, senator. We see that in terms of the inflation numbers that we follow, but we also look at other factors at play. For example, when you look at the Consumer Price Index, you see the impact of energy prices.
You also see clearly some downward pressure on consumer prices as a result of the imported goods coming into Canada. This decrease is particularly evident in two areas, semi-durable goods and consumer durable goods, excluding autos. That decrease reflects the global competition.
At the same time, we have a Canadian economy that is operating at or slightly above capacity, and beginning to show some pressure points. Our job is to add up all these factors at play, and that is what is behind the forecasts we present in our Monetary Policy Report. In the report, we see both the total Consumer Price Index, CPI, and what we call our core measure of inflation moving to our target rate of inflation of 2 per cent — in the case of core, in the second half of this year and certainly for total CPI inflation by the early part of next year.
These forces are competing forces, as you suggest. Our job is to add up these competing forces and get a sense of what the overall situation is — the pressures on inflation and the appropriate policy response to that.
Senator Fitzpatrick: I was getting at the fact that those things are happening now. Is holding inflation at that level having an impact?
Mr. Jenkins: We are certainly seeing forces that represent some upward pressure on inflation. We are also seeing forces that represent some downward pressure on inflation.
As we indicate in our report, in terms of the balance of forces, we see inflation moving back to our 2 per cent target, but we also indicate, in line with the outlook, that it might require some modest further increase in the policy interest rate. However, as the governor indicated, we reassess that at every policy-decision day.
Senator Tkachuk: I would like to follow up on what Senator Fitzpatrick was talking about. In your brief you say that you are meeting your two-per-cent inflationary targets despite the price of energy. Therefore, some corrections must be going on with other prices to allow that to happen. The dollar is now at 90 cents, compared to the U.S. dollar. I am in favour of a strong dollar, and its rise has been rapid; yet, over the last year, there has been a 20 per cent increase in the price of cash and the price of money. Mortgage rates, for example, have gone from 3.9 per cent to 5 per cent, and the prime rate has gone up one full point. That increase by itself must be inflationary. If your targets are being met and we are below the interest rates of the United States, what is driving the bank to raise the price of money?
Mr. Dodge: Our job, as you know, is to keep inflation on track over the medium term. Following the downturn in 2000 and then the 9/11 crisis in 2001, we went through a period of low interest rates in Canada, as did the United States. Not only our policy rate but also long-term rates went to extraordinarily low levels. From 2003 onward, we in Canada have tried to hold our rates down a little to allow the economy to adjust to the higher exchange rate for the Canadian dollar. We have been slower to move rates back up than the United States.
At the moment, we have long interest rates at historic lows relative to U.S. rates, and low nominal levels. We have long-term government rates at about 4.4 per cent, which, for those of you who can think back to conversion-loan days, is exactly where we were in the mid-1950s. We are at nominal levels, at very low rates, and we are at historically low levels relative to the United States out at the long end of the curve.
One might say that it does not seem right at a time when we are bumping against capacity. Part of the reason we have a policy rate that is still relatively low is we want to assess carefully the impact of what we have done so far and look at the interaction with the exchange rate.
The premise that we have high rates is not quite right, senator.
Senator Tkachuk: Just because we do not have high rates does not mean that they have not gone up. They have gone up 20 per cent. The bank stimulated the economy with low interest rates. We had low interest rates, the economy was stimulated and people were working. Our dollar is getting stronger, but business has to have time to adjust to a strong dollar. It will be difficult for business to adjust to the jump of the dollar that has taken place over the last six months to a year. You are exacerbating it by pushing up the interest rates.
It is not an answer to say that just because it is cheap, it has not gone up. It has gone up, and I am asking why it had to go up so quickly at the same time that the dollar was skyrocketing toward 90 cents.
Mr. Dodge: The short answer is that we believe that increase is necessary to keep inflation on track at 2 per cent over the medium term.
Senator Tkachuk: It will definitely put everybody out of work.
Senator Moore: Mr. Governor, there is a little piece in The Globe and Mail of last Friday where you were asked from a public policy point of view what is needed most for Canada to move beyond its current economic structure. You are quoted as saying:
The best thing governments can do is to adopt policies that maximize our flexibility in the face of a constantly changing global economy.
In other words, let markets do their work. We need sound macroeconomic policies — fiscal policy that keeps the government accounts in balance and monetary policy that keeps inflation low, stable and predictable. And we need policies that reduce barriers to the movement of resources from one sector to another and that allow goods and services to flow freely across regions in response to differences in economic performance.
In addition to these global influences you talked about with regard to demand for energy and products, et cetera, Alberta and B.C. announced they were removing barriers, which, it is predicted, will stimulate both their economies by hundreds of millions of dollars. What would happen if we had a similar removal of barriers across the country? What would it do in terms of our economy? Secondly, if we had one securities regulator, how would those things impact on our internal economy, aside from the global influences we have heard about today?
Mr. Dodge: The removal of barriers that allow labour to move freely across the country would be very helpful. I cannot give you a precise number, but I can say that we have been working on that issue for 40 years, having made disappointingly little progress. Personally, I was pleased to see the Alberta-B.C. agreement. It would be nice if all provinces could enter into a similar agreement, and licensed professionals and tradesmen could move freely across the country and have their credentials recognized in all provinces. Undoubtedly, that would increase the flexibility of the Canadian economy.
With respect to securities regulation, I do not want to be drawn into the debate on whether it has to be a single regulator or whether there are various structural forms. What is important, whether or not it is a single regulator, is that we have a common set of rules for capital market in Canada so that an issuer can register in one place and know that the rules that he or she faces or that that company faces are the same right across the country. That is what is really important.
Second, we should be careful not to concentrate only on form. Substance, here, is extraordinarily important. We must recognize that in this country we have not only companies that do business all over the world that need to issue in New York and London, and, hence, would have to play by New York and London rules, but also a lot of medium and smaller companies that are issuing in Canada and doing business in Canada. We need rules and, in particular, applications of the rules — principles are the same for everybody — that are appropriate.
Obviously, the detailed rules that are appropriate for a small mining company or a small start-up high-tech company can be very different than those that apply to the Royal Bank of Canada, for example. However, the intent is the same, namely, to ensure that there is reasonable disclosure to the purchaser of those securities.
Senator Moore: In the U.S., there is concern about the increasing number of public offerings through the London Stock Exchange to the point that NASDAQ has offered to buy the London Stock Exchange.
NASDAQ says it is because of the frustration of trying to meet the ``Enron principles,'' the rules of the Sarbanes- Oxley Act, SOX, put in following those debacles in the U.S. With regard to the economy, is it possible we do not have a single regulator? Could people look abroad for their financings?
Mr. Dodge: Sure. We are in competition with New York, London and Australia. Australia has recently managed not only to consolidate their exchanges but also to move forward in terms of securities regulation. It is important that we do it.
The Canadian Securities Administrators, CSA, have agreed on a way to handle the issue of internal controls. It is a sensible way that is appropriate for Canadian corporations and will not put everybody through the same hoops that New York issuers must go through to conform with SOX 404 regulations. If you read section 404 of the Sarbanes- Oxley Act, it is about this long. The package of regulations pursuant to that is about that thick.
The Chairman: I am delighted that Senator Eyton has now joined our committee. He is an old friend but a new member of this committee. Welcome, Senator Eyton.
Senator Eyton: Thank you, Mr. Chairman. I may look and sound like a rookie as well.
I have spent a considerable part of my life trying to avoid risk, for the most part unsuccessfully. However, I was intrigued by part of your opening comments, when you said that there are both upside and downside risks to the bank's projections for growth in inflation. You said that the bank judges ``that these risks are roughly balanced...with a small tilt to the downside later in the projection period'' and that you consider this risk to be slightly smaller than previously judged.
All of this makes me just a tiny bit nervous. It seems to me that you are riding a frisky animal and there are a whole variety of considerations.
I want to talk about the risk as it may relate to the Canadian dollar. All of us have read different projections and the projections all seem to be higher, whether it is a bank, an economist or an international body. The ranges I see most frequently are for our Canadian dollar to be well north of 90 cents, probably in the mid-90s. I think the national bank was calling for parity by the end of next year. All of that has direct consequences to the Canadian economy.
Has the bank considered that potential scenario? Do you think that is likely in today's circumstances?
Mr. Dodge: As you know, markets often tend to overshoot, but in our experience market analysts are prone to much greater overshooting than markets themselves. When the Canadian dollar was sitting at 62 cents or 63 cents U.S., the analysts said saying 50 cents was the next stop. Now that we are sitting at 90 cents they are all saying parity is the next stop. There is an understandable but nevertheless a real tendency to exaggerate movements.
As we pointed out in January a year ago — and I will turn to Mr. Jenkins to go through this again, because it is important that you and Canadians understand how we look at this — some fundamental factors drive things and then there are what we call type two factors. Clearly, in terms of monetary policy, we must be cognizant and think through the issues of what is actually driving our policy response.
May I turn to you now, Mr. Jenkins? This issue is important and I think it is often not understood as well as it should be.
Mr. Jenkins: Yes, absolutely, this issue is critical when we set monetary policy. When the exchange rate moves, senator, the first thing we ask is: Why is it moving? If it is moving as a result of developments in the world economy that represent neither an increase or a decrease in demand for Canadian products, then we feel that the exchange rate is fulfilling its appropriate role as a market price adjusting to what happens in the world. If you think back to the Asian crises, when the world economy was weak and commodity prices were under a lot of downward pressure, the Canadian dollar adjusted downward in response to that. Over the last few years, we have seen more or less the reverse of that, with the global economy and commodity prices strong and the Canadian dollar appreciating in response to that strength.
Around that appreciation, as a number of you have noted, the speed of appreciation and the level of the dollar has created stress for certain sectors of our economy. We are well aware of that. You need to ask the fundamental question, namely, why is the exchange rate moving, to help you understand what the appropriate policy response is.
I have described what we call, and the governor referred to it earlier, a type-one movement in the exchange rate. There are other reasons the exchange rate can move. It can move based on factors that really do not have any direct bearing on what is happening in the Canadian economy. For example, if the U.S. dollar comes under downward pressure because of its large current-account deficit, that does not reflect any creation of demand in the world. It does not reflect any demand for Canadian products. It is a market adjustment to the fact that the U.S. is running this large current-account deficit. In that circumstance, we need to understand why the dollar is moving, but the implications of that for Canadian monetary policy are different than our type-one movement.
It is a complicated and very good question. We try to lay out our thinking. That is, how do we think about the exchange rate, what we call the paradigm or framework within which we think about these issues so that market analysts, as they see information unfold, can think about it in the same context.
That is a good question. It is something that we pay a great deal of attention to and look at closely to try to understand.
Senator Fitzpatrick: Can I pose a supplementary question? I think my issue is related, but you will have to clarify it for me.
One thing happening vis-à-vis the exchange rate is the purchase of gold and the gold price going up. To the extent that gold is bought instead of American dollars, is that dampening the effect on the Canadian dollar? Can you comment on what you think is happening with respect to gold?
Mr. Dodge: With respect to the Canadian dollar, base metals are much more important than gold in the determination of what is going on. We are a small exporter of gold but a big exporter of base metals. As you know, and if you look at the charts, we have had an upward slope on gold and a number of the base metals. That slope is much more important than what is going on right now.
The Chairman: I allowed Senator Fitzpatrick to bootleg that. I will be a little stricter. Senator Eyton, do you have a final, brief supplemental question?
Senator Eyton: It is a supplemental question but it may require a longer answer.
Obviously, the high dollar and the high exchange rate have differing impacts on various sectors and regions. Can you comment briefly on the ability of the Canadian economy to respond to that kind of pressure.
Mr. Dodge: Senator, you have pointed out correctly that some sectors have difficulty adjusting, not only to the movement of the Canadian dollar but also to the increased competition, particularly from Asia. This situation makes it difficult for manufacturers of consumer goods, and in particular, textiles, furniture and so on.
Those sectors are shrinking. Producers in Canada are finding ways to economize on the use of labour, and to outsource overseas. We have seen a decline in employment in the manufacturing sector, roughly 7 or 8 per cent, over the last 18 months, which is approximately equal to the increase of about 10 per cent that we had in the employment and manufacturing sector after the dollar depreciated in 1997.
The market here is working. That is not to say that it is easy for the companies involved or, in particular, for some of the workers, especially when they are in more remote areas of the country. In deep labour markets, in the Montreal Plain or the Greater Toronto Area, GTA, the situation is not so bad. At least those workers can move to other jobs. The situation is more difficult for workers in a remote community. Clearly, we are sensitive to that.
Senator, you and I have lived through a number of these experiences in the 1970s and the 1980s. The adjustment in the Canadian economy that is taking place at this time is much more rapid than the one that took place in either of those other periods. We have kept demand relatively high. Parts of the economy are strong, unlike the early 1990s, when we went through a difficult adjustment period. Adjustment is taking place, difficult as it is for a number of workers and firms.
The Chairman: We now have Senator Harb, and then Senator Di Nino, both from Ontario.
Senator Harb: I was interested in Mr. Jenkins' comment about the possibility of the trade balance being a factor in the decline of the U.S. currency. Are there other factors, such as the deficit in the U.S. and the fact that some countries, such as China, are taking part of their reserve that used to hold U.S. currencies and moving it into euros and other currencies.
I believe you partly answered my question in your response to Senator Fitzpatrick. While commodities do not seem to be affected, the manufacturing sector, goods and, to a large extent, services are feeling the brunt of that. The technology sector is also sensitive to currency prices.
Are you aware of whether currency printing is taking place south of the border? Is someone printing dollars with the idea in the back of their mind that it could perhaps trigger more economic activity and make the U.S. cheaper on purpose to allow for exports from the U.S.
If that is the case, at what point would you decide that it might be time for us, since our currency will be almost at par with the U.S., to also crank up the printer and put more currency on the market.
The Chairman: Governor, we would be interested in both your comments on that.
Mr. Jenkins: Thinking about the U.S. crank on deficit is the correct way to think about this global imbalance. You are absolutely right, senator. The U.S. does have a large fiscal deficit as well, but the current account deficit is the summary measure of the low level of savings across the United States, not just savings by governments but the low level of savings in the household sector.
Fundamentally, the U.S. economy is consuming more than it is producing. Thus, it is running this current account deficit, largely financed by countries that are running surpluses in Asia, but not exclusively. Increasingly, coming back to the question of energy prices, the oil producers are accumulating surpluses as well.
Fundamentally, you see the Asian countries with a current account surplus and also running up large levels of foreign exchange reserves, which they are investing in the United States. That is the source of savings that enables the U.S. to run this current account deficit.
This question gets into a broader set of issues that the governor and the bank have discussed publicly, the issue of exchange-rate regimes in Asia and the market-based mechanisms that we believe will be important in resolving these current account deficits. One of those is greater exchange-rate flexibility. We can come back to that, if you like.
Let me take a stab at the last part of your question. The governor can then pitch in.
If you look at what is happening to policy in the United States, the Federal Reserve has been raising interest rates, because they went through a long period where rates were low to support the U.S. economy when it was going through a period of slow growth. This increase in interest rates in the United States will have the effect of generating higher levels of savings in the United States, that is, less consumption on the part of U.S. consumers. This effect is part of what we call the rotation of demand that we want to see. We want to see more U.S. growth based on exports and less based on domestic demand. I do not like to use the phrase, ``printing money,'' but in a sense, we believe U.S. monetary policy, by raising interest rates, is helping to facilitate this adjustment that we think is necessary. It is helping this rotation of demand in the U.S. economy that we would like to see across the world economy.
The Chairman: Governor, would you like to add a brief comment?
Mr. Dodge: Mr. Jenkins said it more quickly than I would have.
Senator Di Nino: I want to go back to the rise of the Canadian dollar. I would like to put it in these terms: The rapid rise of the Canadian dollar, which is at least in part due to the wealth created by the oil industry out west, is having a negative impact on Central Canada. I speak particularly of the Ontario manufacturing sector. The resulting rise in interest rates is beginning to impact the housing industry, which could have a more negative and devastating affect on the Ontario economy.
Governor, some have suggested that your raising of interest rates at the same time that the Canadian dollar is strengthening so rapidly should be considered in terms of the central Canada economy.
Mr. Dodge: As we have said many times, senator, we can run only one policy, and that policy must be appropriate for Canada as a whole. The economic weight of central Canada is about two-thirds so, obviously, if we run it for Canada as a whole, the great weight is in central Canada.
On governing council, we believe that our moves to date have been appropriate to ensure that inflation stays on track at about 2 per cent over the medium term. It is often assumed that there are no inflationary pressures in central Canada but that is not the case. Senator, you mentioned housing. When we appeared before the committee last fall, we thought we would see some cooling off in the housing sector that would lead to declines in the prices of new houses. However, to our surprise, we have watched it go in the other direction, but we do not deem it a crisis or a disaster. We find right across the country, in the Maritimes, central Canada, and the West, significant pressures in the markets for skilled labour, professional people and technical people. Those markets are fairly tight.
It is important to remember the service sector. It is true that for the hospitality sector, the rise in the Canadian dollar vis-a-vis the U.S. dollar hurts because we rely a great deal on car traffic from the United States. We have a rise in gasoline prices and in the exchange rate of the Canadian dollar against the U.S. dollar.
Generally, the service sector has been strong across the country. Employment growth in the service sector, which represents about two-thirds, has been strong. It is true, senator, that in comparison to Alberta and B.C. now, growth rates in Ontario and Quebec look somewhat anaemic. When we compare growth rates in Ontario and Quebec with almost anywhere else in the world, other than Asia, they look pretty good.
On balance, the two-thirds of the economy that is central Canada, and the economy as a whole, are almost at capacity or marginally above that point, as Senator Angus indicated in his first question.
Senator Di Nino: There have been comments that perhaps our ability to act or to react, in effect, is uncompetitive when compared to some countries such as China and India.
Mr. Dodge: The briefest comment I can make was made by us before at the International Monetary Fund, IMF. It would be appropriate for countries in Asia, in particular, China, to allow their currency to adjust upward. That step would be important in helping to resolve these imbalances.
[Translation]
Senator Massicotte: It is always very interesting to hear from you, and it also enables all Canadians to understand the importance of monetary policy in our country and the consequences that it can have on their lifestyles.
You say at the start of your report that it is important to have stable inflation and that all Canadians are better off when monetary policy ensures that inflation remains stable, and consequently, interest rates and economic growth can be stable. The economy has been growing steadily and we have not had any surprises for more than a decade.
However, last week, after issuing the report, you said that inflation, to date, had been quite modest despite the increase in commodity prices; imports are lower. You also said that it is possible this trend may not continue. At the same time, the governor of the Central Bank of the United States said almost the same thing. There are concerns over inflation, as we do not know if consumer prices will continue to offset this trend. Of course, it is always very difficult to predict the future, because there are risks.
Can you tell us about these risks? Is there a risk that inflation will exceed your projections? If yes, could we end up with a 2 or 3 per cent increase in the interest rate, and not just a quarter of a percent? It seems as if the trend has changed in comparison with last week's expectations.
Mr. Dodge: For total CPI, there are two factors. There is energy, and we do not know exactly what will happen, but we anticipate that in the future, especially in 2007-2008, there will not be a very strong upward trend for energy, because the base is now high. For the rest of the total CPI, we are currently anticipating an increase of about 2 per cent. We have already talked about the price of housing. We have talked about the price of services, but there is downward pressure coming from consumption. The index is lower than it was in 1992, which is the basis for the analysis. There are several upward trends, but there are also downward trends. We believe that with the monetary policy in place the trend will be about 2 per cent by the end of the year. There may be some surprises. There is a risk of upward trends and downward trends for the future, but we believe that for 2007-2008, 2 per cent is about the best projection for now.
[English]
The Chairman: In one of your statements, Mr. Dodge, you indicated that you did not take into account the federal government's stated intention to reduce the GST from 7 per cent to 6 per cent. That was at a time when you were holding to your 2 per cent target. Now that GST reduction is an actuality, does this directly affect your projections?
Mr. Dodge: Yes, Mr. Chairman, it will. Our best estimate — in box one, on page 27 of our report — is that this change will lower, from July to July, the total Consumer Price Index, CPI, by roughly 0.6 per cent from what it otherwise would have been. However, it then goes back up; it is a one-time dip. In the rate of increase, it is a 0.6 per cent permanent reduction in the level. For the core, the impact is roughly one-half of a per cent on the core rate.
[Translation]
Senator Massicotte: I have another question. It is about China and the world trade balance. Recently, you made several speeches in New York. This subject is of concern to you and to us all. We hope that Chinese currency will become more flexible so as to allow a balance to be established, especially with the United States. However, we know that the Chinese and the Asian countries have invested huge amounts in American treasury bonds.
Does this jeopardize the balance? Are there hazards that we cannot resolve? What would be the consequences for the world order and for economics if things did not turn out the way we wish them to?
Mr. Dodge: There is a hazard. We mentioned it on page 30 of our report. We think that this risk has lessened somewhat over the past six months because we are witnessing the beginning of an adjustment in Asian policies. But this is only the beginning of a change in their policies.
I think that the decision made last week by the Central Bank of China to raise its interest rates is not very encouraging for the re-establishment of the global balance of demand. On the other hand, the Chinese government has begun to do something for the rural regions in China, which will increase internal demand in China and help the situation.
So there are certain risks and we take note of them. However, these risks are less worrisome for us now than they were six months ago.
Senator Massicotte: But if the problem is not solved, what will be the consequences for Canada and Canadians?
Mr. Dodge: It will mean a very rapid depreciation of the American dollar, which implies an increase of the value of the Canadian dollar. The most serious risk will probably be a substantial slowdown in worldwide demand, which will make things rather difficult for Canada. This is why, two weeks ago, at the IMF meeting, we worked so hard to reach a consensus and solve this problem. For us, a wide-open economy could be a source of great difficulties.
Mr. Jenkins: Another hazard is that of protectionism, because of the current imbalance.
[English]
Senator St. Germain: Thank you, governor and deputy governor for being here today.
My question will be short. In March, I think you indicated, governor, that you may consider going lower than 2 per cent, as far as a target on inflation. Is that still a possibility, sir?
Mr. Dodge: I indicated that we had done a lot of research in this area. Our research to date does not indicate a huge advantage over the long haul to a lower rate, but perhaps there is a little more advantage than we found when we looked at this five years ago. Some new work was just starting and we really need to continue that work because there are some reasons to believe that, in the future, a somewhat lower target might be more beneficial than the one we have. However, that work is for the future.
Senator St. Germain: My other question concerns West versus East, the regions. Do you measure inflation via regions?
I happen to be from British Columbia, but I am visiting Alberta and doing business there as well with some of my family. It is incredible what is happening in the West. You have virtually zero occupancy rates in motels and hotels right across the country. Everything is escalating.
I recall, years back, being critical in the West, saying they are raising the interest rates to control inflation in the East. You mentioned a demand for petroleum. That demand will stay there. In northeastern British Columbia, my home province, and in Alberta, it is incredible. It is exciting, but there are certain drawbacks to a situation like this for those on fixed incomes and what have you. The price of housing has totally gone through the ceiling.
Will a day come, do you think, when we must look at regions? I know to set the value of the dollar and inflation that we have to look at ourselves as a country. However, regarding that particular region, will we be able to do anything, or will he bank be able to do anything, to mitigate the downside of a runaway economy?
Mr. Dodge: In terms of monetary policy, we have to set it for the country as a whole. To the extent that the demand is created because of the boom in oil and gas, mining and so on is affected in the demand for steel pipe, machinery, equipment, automobiles and so on. It does come back into Central Canada and spread itself out.
We have to set policy at the bank for the country as a whole; but I would go back to the earlier question raised about flexibility. To the extent we can have more flexible labour and product markets in this country, we can deal with these divergences across sectors or regions much better.
The Chairman: Governor, you will be pleased to know that one of our next terms of reference is to deal with the interprovincial trade barriers and their impediments to developing a national economy. This committee does not believe we have a national economy; we have a fragmented economy, despite your wise efforts.
Senator Goldstein: There is a quote in The Globe and Mail this morning, with two consequences drawn by the person making the quote. I want to take the liberty of reading the quote and ask for your comments with respect to each of the consequences.
The quote is from Jason Myers, chief economist at the Canadian Manufacturers & Exporters.
He cautioned that, ``the budget could spur enough consumer spending to put pressure on Mr. Dodge to maintain higher interest rates — and a valuable loonie.''
Here is the first quotation:
A 1 per cent increase in the value of the dollar is going to wipe out a lot of those benefits that might be there in the budget.
I would like to have your comments on that.
Here is the second quotation:
Mr. Myers said a higher dollar will lead to the end of more Canadian product lines and further layoffs. ``I wouldn't be surprised if we saw another 100,000 net job losses in the manufacturing sector across Canada for 2006.''
I would like your comment on each of those quotations.
Mr. Dodge: I can be brief, Mr. Chairman.
With respect to the impact of yesterday's budget on how we would look at the impact on the economy, from a macroeconomic point of view, the government has done exactly what we assumed it would do, in the sense that it brought down a budget that anticipates a small surplus. We have assumed that governments as a whole, federal and provincial, will run budgets that are roughly in balance or in a small surplus. From that point of view, it is exactly what we had assumed.
However, we had done our assumption on the basis that government expenditure would rise to meet revenues. In fact, the government has reduced the rate of growth of revenues over what otherwise would have been. To the extent one gets an effect, doing it that way has a slight contractionary effect, not at all huge, but it is certainly not in the direction that Jason Myers indicated.
With respect to the second question, frankly, we think there is still a tale to come in terms of employment in the manufacturing sector as a whole. While some components are doing well, others will shrink further, so we are painfully aware of the difficulties of the adjustment that is still to come in the economy.
Senator Goldstein: My second question relates to the effects of the reduction of the GST from a macroeconomic perspective by comparison to what would happen to the economy if the equivalent quantity of money were sacrificed by a reduction of income taxes.
Mr. Dodge: I would never apply the word ``sacrifice'' to tax reduction. We have done nothing further than the standard economic analysis, and standard economic analysis would say that an equivalent amount of reduction of consumption taxes as compared to income taxes would marginally reduce savings rates. A reduction in income taxes, as opposed to consumption taxes, would be marginally more favourable to investment. However, we are talking about marginal differences, and that standard economic analysis does not take into account the situation at the moment. That is what standard analysis would say.
[Translation]
Senator Hervieux-Payette: I have two questions. The first one is about risk analysis. If there were an intervention in Iran by the end of this year, either by the United Nations or by the United Stated, and this again involves oil, energy and other difficult matters, would you see this as a risk factor?
And this is my second question: When you raise interest rates by even a quarter point, as you go to sleep at night, do you feel any remorse about the 100-billion-dollar debt of Quebec's provincial government and the annual deficit that will not go away for years? Are you also considering provincial economies? Do you have any kind of dialogue with the provinces? One province has a surplus, but Quebec currently has a $ 100-billion debt. Are you also looking at the provincial economies? I understand that some provinces have surpluses — as a matter of fact one province has a surplus — but Quebec has a $ 100-billion debt. You should be aware of the impact of a one per cent increase on Quebec's economy.
Mr. Jenkins: Regarding the first question, as Governor Dodge stated in the report on monetary policy, we have a section that deals with risks and forecasts. One of the factors we mentioned is the geopolitical hazard. Certainly, the greatest risk is occasioned by the price of oil and its impact on the world economy. The answer to your first question is yes, this is an element of our analysis.
Mr. Dodge: The impact of a rise in interest rates on provinces is due above all to long or medium-term rates because of the way that provincial debt is structured, in each and every province. A major success of our policy since 1991 was a reduction of long-term interest rates. Now, we have a 4.4 per cent interest rate over 10 years. This is about half of the rate that we had 15 years ago. This is very helpful to the provinces. The inflation control policy is very important for provincial debt burdens because it keeps medium and long-term rates fairly low.
[English]
Senator Gustafson: My question comes out of the deputy chair's idea of high commodity prices. You are probably well aware that in the grain and oilseed markets, there are no high commodity prices. In fact, a barrel of oil in 1972 was the same price as a bushel of wheat. Today, a bushel of No. 3 durum wheat is $2, and a barrel of oil is in the $75 range. If you put that into an economic perspective, you have a dismal situation on your hand.
Markets were not too bad with a 60-cent dollar, but when you get a 90-cent dollar, it is a different situation. You are talking about 25 per cent of the value of a bushel of canola or whatever. That decrease creates a real challenge.
Do you see any area in which the global market is being opened up, or do we in Canada not understand the global market?
Mr. Dodge: One could be flippant and say, unfortunately, we do not really have a global market in agricultural products because governments all over the world interfere in that market. Hence, those countries such as Canada, that produce these commodities for the world, have to compete against subsidized products from a number of other countries and have to face entry barriers to markets that do not necessarily produce much.
We recognize that it is extraordinarily difficult, and I hope I was careful to say minerals, oil and gas when I was talking about commodity prices because we do not have particularly strong prices for forest products or agricultural products.
Senator Gustafson: Of course, the challenge is a serious one. There is no question about that. I have been here 20 years and I have heard for 20 years that we will get rid of subsidies for the Americans and Europeans. It has not happened. We bought that, I call it a lie.
Senator Moore: It has gone the other way.
Senator Gustafson: We bought that lie for 20 years. The time has come when Canada must look at the situation, from the global prospect, and say: Do we want an agricultural industry or not? I think that had to be said here, at this committee, with influential people who can probably help in the right direction.
The Chairman: Governor, I think our colleague is referring to one of your mandates namely, to mitigate, by its influence, fluctuations in the general level of production, trade, prices and employment as far as possible within the scope of monetary action. They are obviously confronting this issue out West in agricultural commodity prices. Maybe you can see how this fits into your mandate, if at all.
Mr. Dodge: Unfortunately, senator, there is relatively little that we can deal with in terms of monetary policy. It comes back to the issue that is of great concern to us, and to all Canadians; that is, the lack of progress at the Doha round. Mr. Jenkins referred to that in his reply to Senator Massicotte. That risk is very real, namely, the risk of protectionism. We are at greater risk than many other countries because we are an open economy. By talking about this issue to the extent that we can and by doing research on it, which is about what we can do at the bank, we are doing something. It is a risk that we must recognize. I am sure that the Government of Canada and all its employees are doing their best to push that forward, but it is a real risk.
Senator Gustafson: Senator St. Germain was with me and we went to several farm sales. One was a farm sale of 40 quarter-sections of land, some of the best in the country, right against the forty-ninth parallel. It sold for $45,000 a quarter, average. That same land would have sold for $100,000 five or six years ago. Right across the U.S. border, the forty-ninth parallel, that same land is selling for $120,000 a quarter and they are not selling. That is a comparison of the situation as it exists.
Senator St. Germain: To that point —
The Chairman: Senator St. Germain, we will come back to you for another round.
Senator St. Germain: This is a brief supplemental question. Senator Gustafson is correct. You see six farms for sale in one town, where the farmers have brought all their equipment to town and they are only keeping the spraying equipment to kill the weeds on their land, because they cannot afford to plant their crops. Are there any levers that you can pull in your world meetings, governor, which would help this situation. We will lose our agricultural industry, which has been, historically, one of the backbones of our nation. I witnessed it firsthand what Senator Gustafson said in Saskatchewan. It is devastating, not only to the people but also to the culture of the province and all of Western Canada. This situation impacts Ontario as well.
The Chairman: I think the governor has a point. Maybe we could hear from him, if he wants to comment on this.
Mr. Dodge: We certainly raised this issue but it is not our particular territory.
The Chairman: Governor, I have a few questions. We will then have ample room to come back for another round.
I will try to be brief, governor. I raised a supplemental question on the impact of the GST reduction on your forecasts, with respect to interest rates. A press release today said that the central bank last month signalled that more interest rate increases may be in store to forestall inflation.
You indicated to us that the GST reduction had not been taken into account. You have now taken it into account, and you have indicated, if I listened to you correctly, that there would be a real or core increase of 0.6 per cent or 0.5 per cent. Does that mean that this statement will be adjusted, that we cannot foresee in the short run rate increases?
Mr. Dodge: First, Mr. Chairman, let me read exactly what we said.
We said, ``In line with the bank's outlook for the Canadian economy..., some modest further increase in the policy interest rate may be required to keep aggregate supply and demand in balance and inflation on target over the medium term.''
I want to emphasize here again the word ``may'' and I want also to emphasize the words that followed that sentence: The bank, ``will closely monitor evolving economic developments in the Canadian economy in light of the cumulative increase in the policy interest rate since last September.''
That is what we said. What happens, presuming that Parliament passes the government's legislation and, as of July 1, we will have a reduction in the GST? Over the period from July of this year to June of next year, we will have a total CPI that ought to be roughly six tenths of a point less than it otherwise would have been. We thought it would have been roughly 2 per cent or a little less than 2 per cent over that period. We think it should come in somewhere around 1.4 per cent next year or during the first half of next year. The core excludes the impact of taxes. The core still ought to come in at about 2 per cent, as we indicated.
Those are the mechanics. We have said we look through this temporary effect on inflation. We look through to what happens when we come out the other side, if you will. We will continue to operate the policy that looks through that. Only to the extent that we see second round effects from this tax action would it have an influence on monetary policy. That is exactly the policy we have had since 1991, since we began targeting inflation.
The Chairman: Thank you, governor. I think that helps clarify the anticipation of interest rate.
Senator Moore: Supplementary to that, Mr. Chairman, what did you mean by second round effects?
Mr. Dodge: Suppose we saw, because of the temporary decline in the rate of increase in the CPI, that, all of a sudden, everybody adjusted their expectations and started to act as if it would be 1.5 per cent all the time, going forward.
We would then, having lowered those expectations, have a change in the way the system operates, a change in inflation looking forward. When we put in the inflation targeting, we had the introduction of the GST in a temporary spike and we said exactly the same thing. We saw no second-round effects at that time and so we did not have to act. I do not anticipate that we would see second-round effects this time either.
Mr. Jenkins: Part of the reason for that, senator, is that inflation expectations are so well anchored at 2 per cent.
The Chairman: I want to refer you to your mandate again. One of your major mandates is to regulate credit and currency in the interests of the economic life of the nation. That is your primary and paramount responsibility.
As you know, our committee has been studying carefully the financial sector from a consumer protection aspect, and we came across an aberration in the economy that disturbed each and every senator, namely, the growth of payday loans and the cost of credit to certain workers in various sectors. We noticed that interest rates on an annual basis would range from a low of 50 per cent up to 300 or 400 per cent because of the quantum in the short time frame.
We have not yet tabled our report, but I think I can speak on behalf of all senators that it troubled us deeply that somehow the regulation of credit and currency, from the governmental standpoint, from the provincial standpoint, had not taken into account this aberration that was detrimentally affecting the cost of credit to workers and others.
Do you have any comment about that? Have you looked at this issue? We are about to opine on this. I know I did not give you notice of this, but we would be interested in your view. It troubles us deeply.
Mr. Dodge: Mr. Chairman, we really have not looked into this issue, so I do not think that our comments would be helpful to you.
The Chairman: Finally, let me turn to a last comment. We will have to navigate the territory of credit and currency ourselves, and we are prepared to do that, I am sure.
I have spent some time with the people in the Federal Reserve in the United States. They have done some interesting work in terms of regional productivity, to stimulate new engines of growth. We are all concerned about growth. Our committee will study this question as well in the short run.
I noticed, looking at the budget statements, that there were references to productivity, but there was not, to my first glance, a precise or focused activity, or can I say, a tax focus on improving productivity.
Governor, we have heard of recent changes from Statistics Canada in terms of measuring productivity and the difficulties of that. Could you give us some insight into what your plans are to study more carefully the issue of productivity? To my mind, and I think to the minds of all members of the committee, productivity and growth go hand in hand, and we are mightily concerned in this committee to ensure that growth continues.
Mr. Dodge: Mr. Chairman, if you will allow me, I will answer your question and Senator Angus's third question at the same time, because they are extraordinarily important questions.
Senator Angus: I was going to get to it next, so it is fine with me. I am glad you have not forgotten.
The Chairman: You can see, governor, that we are ad idem on many points.
Mr. Dodge: Let me start, and then I will ask Mr. Jenkins to finish up.
Obviously, the issue of productivity is extraordinarily important to Canadians. Over the long haul, that is what allows us higher standards of living, and we should all be concerned about this issue.
With respect to our own, if you will, narrow concern, when we put together monetary policy, we essentially assume that labour productivity will grow at roughly 1.75 per cent. We know that this growth will not take place year in and year out. Indeed, we had low rates of growth of measured productivity at the beginning of this decade, and we are getting a little bit worried that our assumption about the capacity of the economy growing at 3 per cent per year might have been too optimistic. Indeed, as we said in front of this committee a year ago, maybe we need to shade down in the short run our measure of capacity.
What we think has happened since 2004 is that we are seeing certainly some cyclical increase in productivity. We will get revised numbers for 2004, which might have some small productivity revision, at the end of May. A year from now we will get revisions to 2005, and so on.
We think that we are seeing some cyclical impact. We are seeing higher levels of investment, and that should produce higher levels of labour productivity going forward in the short run.
Senator Moore: Is that in plant?
Mr. Dodge: Plant and equipment. Machinery and equipment, actually, is the major factor there.
We think that we are getting, if you will, a cyclical rebound. Hence, we are a little more comfortable with our assumption of a 3 per cent capacity growth in the economy going forward than we were a couple years ago, when we started to get a little nervous.
However, I stress that increase is kind of a cyclical rebound. This does not in any way diminish the importance of following structural policies that will increase productivity over time.
Let me turn to Mr. Jenkins to say a few words about this, because it is essential in going forward.
Mr. Jenkins: We have a strong research program on the issue of productivity and we are looking at it from a number of different perspectives. As the governor mentioned, productivity growth feeds into our estimates of potential output growth. Getting to your question, senator, the rate of growth of potential is critical in terms of our judgments with regard to monetary policy.
To answer the senator's first question, we speak in terms of growth rates for the Canadian economy, but we also have to think at any point in terms of the level of activity in the economy. If we think that the economy is operating at a level well below what it is capable of producing, then we obviously want to support the economy and move it back up to its production capacity. That is where we would run low interest rates to support the economy.
If we see that the economy is operating above its production capacity or that there is a risk of such occurring, then we want to moderate the economy somewhat to keep it on that sustained-growth path over time.
That is where a lot of judgment comes into the setting of monetary policy, because we do not have any direct estimate of what that capacity level actually is. We look at a number of different indicators across the economy — we use models and data and we talk to people through our regional offices — to judge the level of the economy relative to its production capacity at any point in time.
The Chairman: Governor and deputy governor, I am looking at the clock. We have five minutes and I have five senators that wish to ask questions. What I would propose is that the senators ask their questions ad seriatim. You can answer what you can by six o'clock, and anything that cannot be answered, you might respond in writing.
Senator Angus: Thank you for coming back to that capacity question. Although I find it confusing, as the average Canadian would, it is important. Governor, you commented on taking the 1 per cent reduction in GST into account for your other projections. However, you did not comment on the effect of the $20 billion in other tax reductions contained in Budget 2006. Would there be an effect, as I believe the Minister of Finance intends?
The Chairman: I ask for questions from other senators before the governor responds.
[Translation]
Senator Massicotte: My question follows up on the subject of productivity. We heard about India, Brazil and China. Of course, we must be competitive. If we were to make a forecast for the 10 years to come, what would be our record regarding competitiveness with those countries? Is there some major shortcoming or something that must be attended to right away?
[English]
Senator Eyton: We applaud the consumer, but is there a specific level of overall consumer debt that would concern the Bank of Canada? What would that level be?
Senator Di Nino: How does the national debt influence monetary policy?
Senator Moore: The Conference Board of Canada issued a report last week on different goals to which Canada should aspire to become more competitive. One goal was to double private-sector investment in research and development and in innovation over the next ten years. With that, I am reminded of the increasing number of income trusts. The philosophy of those entities seems to be to distribute the revenues generated as opposed to retain and invest them in research and development. Have you looked at that? Is that a concern? You mentioned today that there seems to be an increase in investment. Is there concern that kind of financing will lead to fewer dollars available for investment in research and development and, hence, will inhibit the competitiveness of our future economy?
Mr. Dodge: I will take the questions on budget balance and debt because those are roughly the same. As I said, we look at the balance between revenue and expenditures. We assume that governments will keep those elements roughly in balance and we make policy on that basis. What we heard yesterday from the government does not alter anything that we have in here. The level of debt clearly has an influence in terms of the level of confidence that the world has in Canada. We are one of the low-government-debt nations and that is one reason we can have long-term interest rates well below the rates in the U.S.
Senators, I will make one point in closing. It is extremely important for all Canadians to recognize that each time we make a monetary policy decision we do it on the basis of all evidence available at the time. One ought not to ever prejudge exactly what we will do. One should always look at our paradigm and plug in your views on the Canadian economies and, from there, go to your judgment about what we ought to do.
The Chairman: Thank you, Mr. Dodge and Mr. Jenkins, for appearing today. We look forward to hearing from you in the future. We invite Canadians to respond to any or all of the questions or answers. I thank senators for their patience because we had many more questioners than we had time.
The committee adjourned.