Bank of Canada Review - Summer 2000

The Changing Face of Central Banking in the 1990s

During the 1990s, central banks in the industrialized countries made important changes in the way they operate. As part of these initiatives, central banks have endeavoured to define a set of best practices, learning from each other in the process. The goal was to improve and adapt the frameworks within which monetary policy is implemented.

Clarifying Objectives

A clear objective is a necessary starting point for any policy framework. The growing consensus that price stability is the most appropriate objective for monetary policy was perhaps one of the most critical developments of the past decade. Price stability is now universally regarded as the key contribution that monetary policy can make to promote sustainable growth and maximize the level of employment.

Central banks also need a clear strategy for achieving their objective. A major development of the past decade was the growing popularity of inflation targets as the numerical focus for monetary policy. Clearly defined inflation targets focus policy on the variable that is directly associated with price stability. The Bank of Canada was one of the first to adopt (in 1991) a set of targets for inflation over a specified time horizon.

Accountability

Many central banks have acquired greater independence and this, together with the public's desire for more information from key public institutions, has raised the standards for accountability. At the same time, explicit targets provide a clear measure against which to judge the performance of the monetary authorities.

Increased accountability also has implications for the overall transparency of the monetary authorities. In sum, central banks have become much more open institutions and are placing greater emphasis on their communications activities. As an example, comprehensive inflation reports have become key communications vehicles for a number of central banks.

Many of the changes implemented by central banks stem from the desire to improve the credibility of monetary policy, thus making it easier for monetary authorities to achieve their objectives. Although it is difficult to ascertain the overall effect of the evolving policy framework, it is encouraging that inflation and inflation expectations were at low levels at the end of the 1990s, thus providing a solid base for monetary policy in the future.

Restructuring in the Canadian Economy: A Survey of Firms

Towards the end of the 1980s and into the early 1990s, the Canadian economy experienced a number of structural changes. These included free trade agreements (both the FTA and NAFTA), significant technological advances, deregulation in many sectors of the economy, the arrival of large, U.S.-based retailers, and the introduction of the GST. The restructuring associated with these developments may partly explain the rather lacklustre performance of output and employment growth in the first half of the 1990s.

The Survey

The connection between corporate restructuring and employment is difficult to assess analytically. It is, however, useful to ask companies directly about their experiences. For this reason, the Bank's regional offices conducted a survey of 140 companies to ascertain whether restructuring had been more intensive in the 1990s than in the 1980s, and how this affected employment at the firm level.

The broad results of the survey are clear—the degree of restructuring was greater in the 1990s than in the 1980s (Table 1). Restructuring included operational as well as workforce adjustments, and the most common form of restructuring was investing in new technology (Table 3). When companies were asked why they restructured, the most common response was the availability of new technology.

Competition has also influenced firms to restructure. This factor was cited second after the affordability of new technology (Table 4).

Employment Effects

The results indicate that many firms did reduce staff as part of their restructuring efforts. Reasons for the reductions included competitive pressures and investment in new technology (Table 6). The survey also attempted to gauge the amount of "churning" or change in the composition of the workforce. The change identified most frequently, especially in the 1990s, was the need for more highly skilled workers. Companies required employees to be adaptable and to change career paths more frequently. This is consistent with the growing investment in new technology.

Outlook

Companies that had weathered the shocks of the 1980s and 1990s were optimistic. Indeed, the recent performance of the economy would suggest that some of the negative impacts of restructuring are now over. Productivity did pick up in the late 1990s, and it is likely that further gains from restructuring are still to come.

Approaches to Current Stock Market Valuations

The increase in North American stock prices in 1999 and early 2000 has generated interest in the valuation assumptions that would make these price levels sustainable. Here, commonly used valuation techniques are applied to stock markets in Canada and the United States.

For the comparative yield approach, real interest rates (rather than nominal rates) are preferred as the comparator of choice to yields on stock market indexes. The spreads between real interest rates and stock market yields have generally increased over the last two years.

The dividend-discount model (DDM) approach provides an analytic linkage between the equity-risk premium and the expected growth of dividends. It suggests that market values (measured at the end of February 2000) could be sustained only by rapid growth of dividends in the future or by the continued assumption of an uncharacteristically low risk premium on equity.

The spectacular rise in the value of technology stocks in 1999 is noted (Chart 4), and then the valuation measures for the Canadian stock market excluding the technology sector are examined. When this is done with the comparative yield approach, yield spreads are slightly lower, and for the DDM approach, one does not need to assume as high a growth of dividends or as low a risk premium to validate market valuations.

Two effects of the "new economy" on the stock market are noted. One is the lowering of dividend yields, as new-economy technology companies tend to have a high reinvestment rate and a low dividend payout rate. Another relates to the potential for a higher track for the economy's productivity growth, which would mean that higher-than-historical assumptions about future earnings growth would be more plausible.

Several explanations for the decline in risk premiums on equity are considered. While short-term volatility in the stock market has, if anything, increased in recent years, low inflation and improved economic performance, along with demographics and investor preferences, may have contributed to a decline in the risk premium demanded by investors.

A scenario of rapid growth of dividends in the near term slowing to historical norms in the longer term is examined. While this approach can go partway towards explaining high stock market valuations, it requires assumptions that are outside historical experience.