Full text of the speech from Bank of Canada Governor Poloz

Full text of the speech from Bank of Canada Governor Poloz Sept 16 2014:

Float of the Loonie

Introduction

Thank you for inviting me to be here with you today. It’s
great to be back, but I guess you know I have changed jobs since
I last saw you.

Companies in this region have gone through very difficult
times in the wake of the global financial crisis – as have many
across Canada. We’re in a better place now, but our economy is
still not back to normal. So I appreciate the opportunity to
come and meet with you to understand your situation better and
share with you what’s on my mind.
As entrepreneurs, I’m sure you know that global trade has
recovered only partially, as the world economy is still working
through the fallout from the crisis. Compounding the issue for
exporters, of course, has been the relative strength of the
loonie. While it has come down in the past several months, it is
still more than 40 per cent higher than it was in the early
2000s.
Many people in this room may be wondering why the Bank of
Canada did not do more to limit the appreciation of the loonie,
or to weaken it after it rose. After all, we have said time and
again that stronger exports are needed to bring our economy
home.
In my remarks today, I will do my best to answer that
question. If I do my job well, you will leave with an
understanding of why it’s a bad idea to try to manipulate
exchange rates. I’ll give you some context and explain the role
of the exchange rate in the Bank’s inflation-targeting
framework. And I will talk about what we believe is needed to
help our economy eventually return home, to balanced and
sustainable growth.

Targeting Inflation: The Bank’s Best Contribution to Canada’s
Economic Well-Being
The Bank of Canada’s mandate is to promote Canada’s
economic and financial welfare. We do that by targeting
inflation, as measured by the consumer price index. Our target
range is 1 to 3 per cent, with the Bank’s monetary policy aimed
at keeping inflation at the 2 per cent target midpoint. In
pursuing this target, we set in place the necessary conditions
for strong, sustainable economic growth.
A low and stable inflation rate allows businesses and
consumers to make financial decisions with confidence that the
value of their money won’t be eroded by inflation. Parents can
put money away to help their children with their education or
for their own retirement without worrying that inflation will
erase the real value of their savings. Businesses can plan
expansions with reasonable forecasts of how inflation will
affect what they will need for wages and investment.
The benefits of inflation control are confirmed by history.
Since the adoption of the inflation-targeting regime in 1991,
inflation has averaged very close to target, economic growth has
been more stable, and unemployment has been lower and less
variable. And, at the height of the crisis, our inflation-
targeting regime and the credibility we have garnered over the
years helped us weather the storm.

Riding the Tides of the Global Economy
Canada’s flexible exchange rate is an essential element of
this monetary policy framework, as it helps us ride the tides of
the global economy.
Our economy is open to the rest of the world. It must be,
for we depend on sales to other countries to support our
standard of living. We have a diversified export sector, but we
depend more on exports of resources than most other advanced
countries.
For that reason, our currency tends to move with commodity
prices, which in turn move with rising or falling global demand.
Indeed, we benefit from having a currency that rides the rising
and falling tides of the global economy. It acts as a buffer.
When the world economy is strong, commodity prices rise and our
currency tends to float up to facilitate the adjustment of our
economy. Similarly, when the world economy is weak, commodity
prices fall, and our currency tends to float down.
It’s like a floating breakwater across the mouth of a
harbour that rises and falls with the tides, but absorbs the
waves to help keep the water in the harbour calm.
Without a freely floating currency, prices, wages and
unemployment could fluctuate markedly, and that would create
havoc for people and businesses. A flexible exchange rate is
essential for us to be able to pursue an independent monetary
policy in the interests of Canada.
Let me illustrate with a “what-if?” scenario. Back in
2002, the Canadian dollar was worth around 65 cents U.S. By
early 2008, it had risen to around parity. The world price of
oil was about $25 per barrel in 2002, but by early 2008, that
price had risen to well over $100.
It would be hard to imagine the Canadian dollar staying in
the mid-60-cent range, given the rise in oil prices. As I’ve
said before, there is a loose but predictable relationship
between oil prices and our currency – like a dog and its master,
when connected by one of those leashes that stretch and rewind.
But let’s just suppose we had tried to stop the Canadian
dollar from rising once it reached around 85 cents, sometime in
2005.
The obvious way to limit the rise in the dollar would have
been for the Bank to cut interest rates. Given the underlying
upward pressure on the dollar coming from rising oil prices, we
estimate that holding the loonie at around 85 cents back in 2005
would have required cutting interest rates from 4 per cent to
almost zero.
As you would expect, the economy would then have two
sources of stimulus – higher prices for oil exports and ultra-
low interest rates, which would have boosted borrowing and
spending.
This combination would have overheated our economy during
2006-08, and inflation would have begun to rise above our
target. We estimate that inflation would have been approaching 4
per cent by 2008.
As an aside, let’s talk about what actually happened in
2008 – the global financial crisis. While it’s tricky to
introduce a slice of reality into a hypothetical scenario, it is
worth noting that if our interest rates were already near zero,
we clearly would have had no room to manoeuvre.
But let’s set aside that complication, and finish our
“what-if?” scenario. By 2008, inflation would have been
approaching 4 per cent and still be rising. Your companies’
costs of production would have been rising by 4 per cent or
more, and export competitiveness would be eroding steadily, even
though we would be holding the exchange rate steady at 85 cents.
And that would not be the end of the story. With its anti-
inflationary credibility increasingly at risk, the Bank would be
forced into action – it would abandon its hypothetical attempt
to control the dollar, interest rates would rise significantly
to slow the excessive growth in the economy, unemployment would
increase and inflation would eventually make its way back down
to target. The exchange rate would have to find its own level at
that point, because the Bank could not both target inflation and
hold the exchange rate constant at the same time.
Although this is just a counterfactual thought experiment,
it is informed by hard analysis. Trying to hold the dollar
constant would give us larger fluctuations in unemployment,
output and inflation, and in the end would not help us maintain
our international competitiveness. It would also mean that we
would have less policy credibility when it came time to take
action during the financial crisis. In short, by targeting the
exchange rate, we would lose our ability to pursue an
independent monetary policy in the interests of Canada.
By the same token, we can imagine a scenario where the U.S.
economy was picking up speed and our economy was lagging. In
such a situation, U.S. interest rates might rise at a time when
maintaining our inflation target would require that Canadian
interest rates remain unchanged. If we were trying to hold the
exchange rate unchanged instead of targeting inflation, we would
probably need to match U.S. interest rate increases in lockstep;
but doing so would risk pushing our inflation rate back below
our target. Again, attempting to control the exchange rate would
mean giving up our independent monetary policy.
Now, none of this means that we are indifferent to exchange
rate movements. In fact, we closely analyze the effects of
exchange rate movements on the economy. Our aim, however, is not
to achieve a specific value for the dollar. It is to achieve our
inflation target.
The best place for the exchange rate to be determined is in
the markets. The markets trade the Canadian dollar toward a
value consistent with the relative fundamentals of our economy
and those of our trading partners. This trading happens around
the clock, and new information is instantly taken into account
by a multitude of participants. Markets are not perfect – they
can overreact, or can break down in times of stress – but they
are our best bet.
Some have argued that the Bank can have it both ways: it
can use interest rates to pursue its inflation target, but
independently intervene in the foreign exchange market to
achieve a more desirable level for the dollar. This means buying
and selling Canadian dollars in exchange for U.S. dollars in the
open marketplace. But, given the depth of the global market, the
Bank would need to undertake truly massive transactions to have
even small effects on the exchange rate. Those effects would be
very short-lived and, in the attempt, thwart the good work that
markets do for us every day.
The only time when such direct intervention in markets
might be practised would be in the case of a breakdown in the
market, in which case the Bank could offer to transact on either
side until normal trading resumed – in short, an emergency
situation where the market fails for some reason.
Still others have suggested that the Bank could offer the
exchange market verbal guidance about what the value of the
dollar should be. Behind this suggestion is a presumption that
the Bank has a better understanding of the macroeconomic
fundamentals driving the dollar than the market. This is a
difficult claim to defend. Our exchange rate depends on a host
of domestic and foreign fundamentals, many of which are beyond
the Bank’s influence. Better that these myriad effects be
weighed, debated and wrestled with in a deep marketplace than in
a simple statistical model developed by the central bank.
In short, I believe in markets. Manipulating or trying to
guide them is just not in our game plan. What the Bank has done
and will continue to do is be as clear as possible about how it
sees the forces at play in the economy, and where the major
sources of uncertainty and risks lie.
To bring this uncertainty more into the policy dialogue, we
have made some changes in the past year to how we analyze and
talk about monetary policy. Our efforts reflect the fact that
the business of central banking is being adapted in real time to
the changing environment.
We have begun putting our growth and inflation forecasts in
the form of ranges rather than points, and have given even more
prominence to uncertainty and risks in the Monetary Policy
Report. We have refined our analysis of financial stability
risks and raised the profile of our Financial System Review.
And, we have begun to offer a more fulsome description of how
those risks are entering our policy deliberations. These changes
have brought more transparency to policy decision making, and
our policy narrative has shifted from one traditionally seen
almost as “mechanical engineering” to one now characterized as
“risk management.”

Getting Home – A Natural Sequence
Let’s talk about that policy narrative now.
In the aftermath of the financial crisis, our export sector
contracted significantly. The household sector picked up much of
the slack in response to record-low interest rates, especially
by investing in housing. But we cannot rely on policy-induced
growth to maintain our living standards forever.
The Canadian economy requires a major rotation toward a
more sustainable growth track. First, we need a substantial
recovery in exports, Canada’s natural engine of economic growth.
From that will follow more investment spending by companies,
accompanied by more employment growth. All of this will help
absorb our spare capacity, bringing inflation sustainably to our
target of 2 per cent. And along the way, there will be a gradual
reduction in our financial stability risks, such as household
imbalances.
This is a natural sequence that we will monitor carefully.
Its starting point, and the most critical ingredient, is a
substantial recovery in exports.
Where will that critical revival of exports come from?
Well, energy exports are already leading the way. This is the
main source of natural growth in our economy today–new energy
exports, new investment, new jobs. Furthermore, higher oil
prices are boosting incomes across the entire country, and that
creates jobs, too. But growth in energy exports alone cannot
make up for the loss of exports we have experienced since the
crisis.
Non-energy exports also will contribute, but they have been
very sluggish for several years, at least until recently. After
a weak start to the year, there has been a surge in non-energy
exports in the past few months. About half of this rebound was
weather-related, as exports were delayed during the winter. But
underneath these fluctuations we are starting to see some early
signs of recovery.
The fact is, though, that the global economy remains an
uncertain place and, as forecasters, we are wary of the serial
disappointment it has delivered us in recent years. Europe is
obviously the biggest question mark. Nonetheless, the U.S.
economy appears to be back on track and is now showing signs of
higher investment spending, which is usually associated with
stronger exports of Canadian machinery and equipment, packaging
materials, industrial materials, and business services. Many of
these sectors are also sensitive to exchange rate fluctuations,
so the lower dollar is providing an additional boost to foreign
sales.
Certainly, we should expect to see our forecast coming true
right here in Drummondville, as this has always been an export-
intensive part of the country. Companies here are investing to
diversify their product lines and their customer bases and are
positioning themselves for new growth. We now see the region’s
traditional focus on textiles and furniture giving way to a
broad range of technical, value-added manufacturing in machinery
and equipment, building and packaging materials, and plastic and
rubber products – some of the very sectors we expect to see
leading our export recovery.
Nevertheless, some other export sectors have been
struggling since well before the financial crisis. For them, the
restructuring road is proving long and difficult, so some of the
lost ground may only be made up over an extended period of time.
We can also expect to see brand-new export activity from
newly created exporting firms. I’m sure I don’t have to remind
this audience that many firms were wiped out in the crisis.
Normally, as the economy gets back to full capacity, the overall
population of businesses picks up and more firms enter the
export markets, creating new products, new services and, most
importantly, new jobs. Unfortunately, company population growth
has been very sluggish since 2008, and preliminary data indicate
this population did not increase at all in 2013. The ingredients
are in place, however, so we remain hopeful that this process
will resume in 2014-15.
All things considered, then, we are cautiously optimistic
about our exporting future. It will take more than a few months
to establish a trend, and then still longer for it to translate
into more investment and hiring by companies, but it looks like
the natural sequence we’ve been hoping for is getting under way.

Conclusion
Let me sum up. It is simply not possible to have a fulsome
discussion of the outlook for Canada’s inflation rate and our
monetary policy without an understanding of the effects the
exchange rate is having on the economy.
But trying to control the loonie is off the table, as far
as we are concerned at the Bank of Canada. A floating loon is a
thing of beauty, and so is a floating loonie, at least from this
economist’s perspective.
Our job is to understand the context, and adjust short-term
interest rates to meet our inflation target. That job is tough
enough. It is the job of the market to watch the economic data
unfold and grind out the implications for other financial
markets, including the exchange rate, on a daily basis. That,
too, is a tough job, but it is not ours.
The fact is, the Bank can’t do its job well unless the
market does its job well, and vice versa. And the Bank has been
working to bring more transparency to the various elements of
uncertainty that have been making its job more difficult, and
this additional transparency is helping the market do a better
job.
And all that is more than just talk – it means that
business people like you can do a good job, too.