Category: Economic

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Economies around the world have become more integrated because of increased trade, and this has implications for the conduct of monetary policy, Bank of Canada Governor Stephen S. Poloz said today.

In the first annual Paul Storer Memorial Lecture on Canada–US relations, given at Western Washington University, Governor Poloz said that the evolution of international trade practices, such as building global value chains and establishing foreign affiliates, suggests that economies are becoming more integrated.

There is “evidence of increased trade integration when the definition of trade is broadened to embrace all the dimensions of international business,” Governor Poloz noted. This evidence “is sufficient for monetary policy to take it seriously.”

Increasing integration has been driven not only by pacts such as the North American Free Trade Agreement but also by the rising trade penetration of emerging markets, particularly China, through the development of global supply chains, Governor Poloz said.

Cross-border integration can matter for monetary policy in several ways, the Governor said. In particular, increased integration can affect the economic models that policy- makers rely on, reducing the economy’s sensitivity to exchange rate fluctuations while making domestic inflation more dependent on international developments. Analysis produced using the Bank of Canada’s main policy model shows that maintaining inflation targets can be more challenging when integration is high, because it may require more variability in interest rates, the exchange rate and the output gap for the same series of macroeconomic shocks.

“Models that do not recognize rising integration are likely to predict that monetary policy actions will be more effective at stabilizing the economy and controlling inflation than they will prove to be in practice,” Governor Poloz stated. “Policy-makers need to acknowledge that international developments will have an influence on their economies.”

The lecture honours the late Paul Storer, former economics professor at Western Washington University who worked with Governor Poloz at the Bank of Canada. Professor Storer, who died last year, specialized in the study of the economic relationship between Canada and the United States, particularly with respect to trade.

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Canadians need to understand the forces that have led to a prolonged period of low interest rates and make adjustments, Bank of Canada Governor Stephen S. Poloz said.

In a speech to the Association des économistes québécois, the Cercle finance du Québec and CFA Québec, Governor Poloz talked about the need for companies and households to adjust to the reality of interest rates that are likely to remain at low levels for a long time. Factors that restrain an economy’s speed limit—particularly aging workforces—are driving down interest rates in many countries.

Lower-for-longer interest rates have made it more difficult for Canadians to finance their retirement through savings, the Governor noted. People are “rightly worried about their ability to live off their savings,” he said. “I certainly can sympathize and understand these concerns.” Longer life expectancy is compounding the challenge because people need to finance a longer retirement period, he added.

Companies also need to adjust to lower interest rates by reducing expectations about future investment returns, the Governor stated. Investment spending has been weaker than expected, and Governor Poloz said one reason may be that some businesses aren’t taking into account the low-interest-rate environment when deciding if an investment will be worthwhile.

If companies are waiting for returns near the levels that prevailed before the crisis, “they are unlikely to invest any time soon, and we will not see the kind of growth, productivity and job creation we are looking for,” Governor Poloz said. “And neither will the companies.”

While there’s little that policy-makers can do about forces such as demographics, much can be done to help offset their impact on interest rates, the Governor noted. This means ensuring that policies in areas such as tax and immigration aren’t obstacles to business growth, and that young companies access financing.

Authorities must also explore every avenue that would boost the economy’s potential growth rate, he said, pointing to investments in productivity-enhancing infrastructure and agreements to liberalize trade, both inside and outside Canada, as steps that could make an important difference over the medium term.

Because the potential growth rate of Canada’s economy has slowed, “we need to take every decimal point of potential growth more seriously than we have in the past,” Governor Poloz said. “In a lower-for-longer world, these are opportunities we simply cannot afford to miss.”

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The decline in the global economy’s potential to grow, and the lower interest rates that come with it, pose risks for financial stability, Bank of Canada Senior Deputy Governor Carolyn Wilkins said today. Those risks can be mitigated through deliberate efforts from the private sector and policy-makers.

“While we typically link financial stability risks to unsustainably high growth, slower growth and lower returns can also add to vulnerabilities in the financial system,” Senior Deputy Governor Wilkins said in a speech to the Official Monetary and Financial Institutions Forum in London, UK.

Economies around the world face the prospect of sluggish growth because the two components driving potential output—labour supply and productivity—are rising more slowly than in the past, she said. The Bank of Canada estimates that global potential GDP growth declined from a peak of about 5 per cent in 2005 to just over 3 per cent this year. This represents about US$1 1/2 trillion in foregone global output for 2016 alone.

“Natural by-products of slower potential growth are not only weaker corporate profits and dividends, but also a lower average rate of return on investments,” Senior Deputy Governor Wilkins said. To gauge this effect, economists estimate the neutral rate (the interest rate needed to balance savings and investment when the economy is operating at potential), which has fallen in Canada to 1 1/4 per cent today, from 3 per cent in the early 2000s. With the policy rate currently at 50 basis points, she noted that monetary policy in Canada remains quite stimulative, although less so than it would have been a decade ago when the neutral rate was higher.

Slower growth and a lower neutral rate heighten financial vulnerabilities through several channels. Households could experience longer and more frequent periods of shrinking incomes, making their debts more burdensome. A lower neutral rate could encourage investors to take on more risks in their search for higher returns. Finally, a lower neutral rate could put pressure on bank business models, opening the door for important financial activities and related risks to migrate to less-regulated entities.

Mitigating these risks will require effort, Senior Deputy Governor Wilkins said. Investors and market participants have to adapt to lower neutral rates. Countries must continue to work to meet their G20 commitments and take fiscal and structural measures that will improve long-term growth and productivity. Authorities have to continue to solidify the global financial system and guard against emerging problems.

“We have to adapt to the new reality of lower potential growth,” she said. “The faster we do this, the safer the financial system will be.”

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