This paper examines economic developments and policies in Canada during 1990–95. Spurred by the robust growth in the United States and the easing of monetary conditions between 1991 and 1993, economic growth in Canada continued to strengthen during 1994. Real GDP grew by 4.5 percent in 1994 after growing by 2.2 percent in 1993 and 0.6 percent in 1992. Economic growth in 1994 was led by exports and investment in machinery and equipment. However, growth was more broadly based in 1994; private consumption strengthened, and there was a rebound in residential and nonresidential construction.

Abstract

This paper examines economic developments and policies in Canada during 1990–95. Spurred by the robust growth in the United States and the easing of monetary conditions between 1991 and 1993, economic growth in Canada continued to strengthen during 1994. Real GDP grew by 4.5 percent in 1994 after growing by 2.2 percent in 1993 and 0.6 percent in 1992. Economic growth in 1994 was led by exports and investment in machinery and equipment. However, growth was more broadly based in 1994; private consumption strengthened, and there was a rebound in residential and nonresidential construction.

VI. Monetary and Exchange Market Developments 1/

1. Monetary policy issues

a. Monetary policy objectives

The objective of monetary policy in Canada is to achieve and maintain price stability. Promoting this objective is viewed by the authorities as the best contribution monetary policy can make to the achievement of sustained growth of the Canadian economy. In order to provide a clear signal of their commitment to lower inflation over the medium term, the Government and the Bank of Canada jointly announced targets for inflation reduction in February 1991. The targets called for the 12-month rate of CPI inflation to decline to ranges of 2 to 4 percent by the end of 1992, 1 1/2 to 3 1/2 percent by mid-1994, and 1 to 3 percent by the end of 1995 (Chart VI-1). In December 1993, the newly-elected Government and the Bank reaffirmed their commitment to price stability and extended the 1995 target range of 1 to 3 percent through the end of 1998. It also was stated at that time that, on the basis of the experience with low inflation over the period, a decision would be made by 1998 on the target range for the CPI that would be consistent with price stability. 2/

CHART VI-1
CHART VI-1

CANADA INFLATION TARGETS AND INTEREST RATES 1/

Citation: IMF Staff Country Reports 1995, 046; 10.5089/9781451806823.002.A006

Source: Statistics Canada (supplied by DRI); and Fund staff estimates.1/ Shaded areas indicate recessions.2/ CPI excluding food and energy prices and (since 1984) the effects of changes in indirect taxes.3/ Nominal interest rates less the 12-month rate of core CPI inflation.

The Bank also has indicated that adjustments to the targets would be made to take into account the impact of changes in indirect taxes on the CPI. However, monetary policy would not accommodate the subsequent pass-through of any change in indirect taxes to prices and the long-run inflation targets would not be adjusted. In fact, indirect tax cuts in February 1994 have meant that inflation, as measured by the overall CPI, has been well below its target range (see Chart VI-1). Excluding the temporary effects of these tax changes, core inflation was in the lower half of the target range during 1994.

b. Monetary policy operations 3/

In order to achieve its goal of price stability, the Bank of Canada makes use of a number of economic variables as indicators of future inflation. The long and variable lags between monetary policy actions and their effects on prices imply that changes in the stance of monetary policy will affect the rate of inflation from four to eight quarters in the future. The Bank uses a broad range of indicators to determine whether the current stance of monetary policy is consistent with a future rate of inflation that is within the target range. 1/ For example, variables that are thought to feed directly into the inflation process include current and projected output gaps, the expected rate of inflation, indirect taxes, and the exchange rate. The Bank also monitors other data that are thought to be more loosely linked to future inflation such as wage data (in particular collective wage settlements) and financial aggregates.

Between formal forecasting exercises, the Bank of Canada has used for the past several years an index measuring changes in the short-term interest rate and the exchange rate as its operational target. 2/ The nominal monetary conditions index (MCI) is a weighted average of the change (in percentage points relative to a base period) in the 3-month commercial paper rate and the percent change in the effective exchange rate relative to a base period (Chart VI-2). The Bank also calculates a real MCI as a function of the short-term interest rate less the expected rate of inflation over three months and a measure of the real effective exchange rate. However, the Bank of Canada tends to rely more on the nominal MCI as a short-term guide for policy.

CHART VI-2
CHART VI-2

CANADA MONETARY AND CREDIT INDICATORS 1/

(Percent change from year ago)

Citation: IMF Staff Country Reports 1995, 046; 10.5089/9781451806823.002.A006

Source: Statistics Canada (supplied by DRI); and Fund staff estimates.1/ Shaded areas indicate recessions.2/ The nominal index is calculated as the change in the 90-day commercial paper rate since January 1987 plus one-third of the percentage change in the (G-10 trade weighted) effective exchange rate, also since January 1987. The real index substitutes the real 90-day commercial paper rate and a real (CPI based; trading partner weighted) effective exchange rate into the calculation.3/ M2-plus includes M2 plus notice deposits of other chartered bonks and notice and personal term deposits booked at investment dealer subsidiaries.4/ Gross M1 includes M1 plus demand deposits of other chartered banks and demand deposits booked at investment bank subsidiaries.

Through its use of the MCI, the Bank of Canada takes into account the effects of exchange rate changes on aggregate demand in setting monetary policy. However, the Canadian authorities do not seek to stabilize the exchange rate at any particular value. Exchange market intervention is symmetric and aims to smooth movements in exchange rates and maintain orderly market conditions. Thus, foreign reserves tend to fall during periods of depreciation and rise during periods of appreciation. 3/ The Bank of Canada generally adjusts domestic interest rates in response to abrupt movements in exchange rates, so as to avoid confusion about monetary policy objectives and to contain spillovers to other financial markets.

The policy instruments used by the Bank of Canada include the Bank rate and the size of the Bank’s balance sheet. The latter determines the supply of liquidity in the money market which in turn directly affects the shortest-term interest rates in the money market. 1/ Beginning in July 1994 the Bank introduced a target range for the call loan rate, which is the overnight interbank loan rate. While the Bank does not explicitly announce the limits of the operating band, they can be inferred on the basis of the Bank’s trading activity in the overnight market.

2. Monetary conditions 2/

Since mid-1990, the Bank of Canada has generally sought to ease monetary conditions in order to support the economic recovery. During 1994 and early 1995, however, this process was complicated by the tightening of monetary conditions by the U.S. Federal Reserve, substantial downward pressure on the Canadian dollar, and evidence that the output gap was closing rapidly. Thus, after falling to a historical low of about minus 4 percent in February-March 1994, the MCI rose thereafter. Despite the decline in the nominal effective exchange value of the Canadian dollar, the MCI reached a level of minus 1 1/2 percent in February-March 1995, reflecting a sharp increase in short-term interest rates (see Chart VI-2).

Short-term interest rates in Canada reached their lowest level in 20 years in January 1994. However, beginning towards the end of that month the Canadian dollar came under substantial downward pressure, owing to concerns regarding the outcome of the upcoming election in Quebec, large fiscal debt and deficits in Canada, and the rise in U.S. interest rates. As a result, short- and long-term rates rose markedly during the first half of the year. During January-June 1994, yields on 3-month treasury bills rose by 2 3/4 percentage points to an average of just under 6.4 percent, and the differential with U.S. Treasury bills rose by 180 basis points (Chart VI-3). Long-term yields also increased sharply; the 10-year government bond rate increased by about 2 3/4 percentage points and the spread versus the U.S. 10-year bond rate rose by about 140 basis points.

CHART VI-3
CHART VI-3

CANADA INTEREST RATE DIFFERENTIALS AND EXCHANGE RATES 1/

Citation: IMF Staff Country Reports 1995, 046; 10.5089/9781451806823.002.A006

Source: Statistics Canada (supplied by DRI); and Fund staff estimates.1/ Shaded areas indicate recessions.

As political and exchange rate-related concerns eased, the Canadian dollar appreciated somewhat during July-September 1994. Consequently, the Bank of Canada encouraged some easing of interest rates in order to maintain the overall level of monetary conditions, and by October the yield on 3-month treasury bills averaged about 5.4 percent. The easing of Canadian short-term rates occurred despite the U.S. Federal Reserve’s actions to raise U.S. short-term rates by about 50 basis points. As a result, the Canada-U.S. differential on 3-month treasury bills fell to about 40 basis points. Long-term yields also fell during this period, but tended to move more closely with U.S. interest rates; the differential fell from about 1 3/4 percent in June to 1 1/4 percent in October.

During November 1994-January 1995, downward pressures on the Canadian dollar became severe. These were related to investor concerns regarding the sustainability of the narrow spread between Canada and U.S. short-term interest rates, especially in light of the Federal Reserve’s actions to tighten monetary conditions in mid-November. The increase in Canadian short-term interest rates during October-November was moderated by the Bank of Canada, on the assumption that Canada’s inflation and cyclical conditions suggested a smaller increase than in the United States.

However, pressures on the dollar intensified during December 1994 and January 1995, related in part to the increased focus by international investors on the Canadian fiscal situation following news of the financial crisis in Orange County, California, and the Mexican currency crisis. The rate on 3-month treasury bills rose to just over 8 percent by end-January and the spread over U.S. interest rates increased to about 225 basis points.

During 1994, the Canadian dollar depreciated by 6 percent relative to the U.S. dollar and 4 percent in real effective terms (based on relative unit labor costs; see Chart VI-3). While recent increases in U.S. interest rates and Canadian political developments contributed to the decline, these exchange rate movements also reflected a continuation of a trend depreciation that began in October 1991. The Canadian dollar depreciated by 23 percent in real effective terms from October 1991 through February 1995, following an equivalent appreciation that began in early 1986. These movements have largely reflected fluctuations in nominal exchange rates, which have tended to follow shifts in Canada-U.S. interest rate differentials and changes in world commodity prices. 1/

3. Monetary and credit developments

Although the Bank of Canada abandoned formal monetary targeting in 1982, the rate of growth of monetary and credit aggregates continue to be monitored. Gross Ml declined in the second half of 1994 in response to the rise in interest rates that began in February, following a sharp increase in the first quarter (see tabulation below and Chart VI-2). 2/ Econometric evidence suggests that real M1 (i.e., Ml deflated by a price index) is a useful leading indicator of real output one to two quarters ahead. 1/ However, special factors appear to have weakened the statistical relationship in 1994. These include a change in chartered bank reporting systems from an average-of-Wednesday basis to a daily-average basis, and a sharp increase in credit balances at chartered bank investment dealer subsidiaries (related to increased financial market trading volumes).

Growth in M2-plus was very weak in the first half of the year, but picked up in the second half. The earlier weakness reflected in large part a shift from M2-plus deposits to mutual funds; some of these funds were shifted back to M2-plus deposits beginning in mid-year as the relative rate of return on term deposits improved. M2-plus is viewed as a useful leading indicator of inflationary pressures, and the Bank of Canada has published econometric results suggesting that M2-plus provides statistically significant information for forecasting inflation one to 16 quarters out. These results suggest, for example, that roughly one third of M2-plus growth would show through to CPI inflation four quarters hence. 2/

Monetary and Credit Aggregates

(Percent change from preceding period at annual rate)

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After growing only modestly in 1992-93, business credit strengthened markedly during the first half of 1994 (see Chart VI-2). The growth of business credit slowed during the latter part of 1994 as higher profits and slower investment growth reduced businesses’ external financing needs. A deceleration in residential mortgage credit also caused the rate of growth of household credit to slow somewhat in the latter half of 1994. However household indebtedness as a share of disposable income, which has shown a steady upward trend since 1984, continued to rise reaching nearly 90 percent by end-1994.

1/

Prepared by Ellen M. Nedde.

2/

The inflation targets are specified in terms of the total CPI, but the CPI excluding food and energy is used for operational purposes.

3/

This section draws on C. Freedman (1994), “The Use of Indicators and of the Monetary Conditions Index in Canada” in T. Balino and C. Cottarelli (eds.) Frameworks for Monetary Stability (Washington, D.C.: International Monetary Fund, 1994).

1/

The Bank of Canada abandoned monetary aggregates as intermediate targets of policy in the early 1980s in response to financial innovations that rendered the demand for money unstable. It has since conducted monetary policy without an intermediate target, which is defined as a variable that is closely linked to the ultimate target of policy (e.g., the rate of inflation) and is influenced by changes in the instruments of policy (e.g., changes to the Bank of Canada balance sheet or interest rates).

2/

An operational target is a variable that is closely linked to the monetary authority’s instruments of policy. Operational targets, unlike intermediate targets, cannot serve as nominal anchors to the system. Previously, the Bank of Canada, like most countries, relied on a short-term interest rate as its operational variable. The background papers to the 1994 consultation discussions (SM/94/97 and Supplement 1, 4/20/94) contain a detailed discussion of the Bank of Canada’s MCI.

3/

Chapter V contains a discussion of recent developments in official financing of the balance of payments.

1/

Specifically, the Bank of Canada implements monetary policy by altering the quantity of clearing balances available to direct clearers by the drawdown/redeposit of government deposits. The Bank also resorts to open market operations as a reinforcing or supporting instrument in order to affect the rate structure at a specific term. Open market operations include special purchase or resale agreements (PRAs) in which the Bank offers to buy short-term securities with an agreement to resell on the next business day; sale and repurchase agreements (SRAs) in which the Bank offers to sell securities to chartered banks under an agreement to purchase them the next day; and outright purchases or sales of treasury bills.

2/

The discussion below is based in part on reports of Canadian financial market developments and monetary policy operations contained in various issues of the Bank of Canada Review.

1/

Canada is a net exporter of commodities, which comprise about 45 percent of Canada’s exports. Thus, there tends to be a correlation between world commodity prices, Canada’s terms of trade, and the value of the Canadian dollar.

2/

Gross Ml rose sharply in December 1994 and January 1995, but this is thought to have been partly the result of inadequate seasonal adjustment.

1/

For a discussion see P. Muller, “The information content of financial aggregates during the 1980s,” Monetary Seminar 90 (Bank of Canada: Ottawa, 1990).

2/

Kevin Clinton, “The term structure of interest rates as a leading indicator of economic activity: A technical note,” Bank of Canada Review, Winter, 1994-1995, pp. 23-40.

Canada: Economic Developments and Policies
Author: International Monetary Fund