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Highlights * Despite some lingering uncertainties on the global scene, developments since the May 1999 Monetary Policy Report have resulted in a firmer tone in the outlook for the world economy and for Canada. * The Canadian economy now appears poised to attain growth in 1999 towards the upper end of the 2 3/4 to 3 3/4 per cent range set out in the May Report. * Trend inflation is still expected to edge up but to remain in the lower half of the Bank's inflation-control target range of 1 to 3 per cent. Information received since early July, when the update to the Monetary Policy Report was completed, continues to point to a generally firmer tone in the outlook for the world economy and for Canada. Nonetheless, lingering uncertainties on the global scene bear watching. In Japan, there are signs that the protracted economic recession may be coming to an end. In Europe, expectations of a pickup in the pace of expansion as the year progresses are becoming more widely held. Economic and financial conditions remain generally positive in those emerging-market economies in Southeast Asia and Latin America that are vigorously pursuing sound domestic policies. In the United States, real GDP rose by an estimated 2.3 per cent in the second quarter—below most expectations. A significant part of the slowdown, however, was attributable to a major inventory adjustment. Growth of real final domestic demand also decelerated, but remained strong at just under 4 per cent, following growth of over 6 per cent in the two previous quarters. Overall, the U.S. economy continues to operate at high levels, thereby heightening concerns about potential inflationary pressures. While inflation at both the retail and producer-price levels appears to be contained, with tight labour markets (employment was up strongly in July) signs of cost pressures have emerged recently, reflecting rising rates of labour compensation and slowing productivity growth. Here in Canada, indicators of domestic demand such as retail and wholesale trade, motor vehicle sales, housing activity, imports, and business investment plans all support a picture of solid expansion through the spring and summer months. Exports, after several quarters of very strong growth, remain at high levels, and economy-wide production data (e.g., monthly GDP at factor cost) through May also indicate a steady, solid pace of expansion. Moreover, world commodity prices have risen somewhat further recently, providing support to Canada’s resource sector. The prices of some key primary commodities produced in Canada (especially energy and base metals) have been among the fastest rising. And as anticipated, there was renewed employment growth in July, notably in full-time, paid jobs. On balance, recent data suggest that real GDP increased by about 3 1/2 per cent (annual rate) in the second quarter—broadly in line with expectations at the time of the July update. The 12-month rate of increase in the core CPI edged up to 1.7 per cent in June. As in the previous two months, the June increase was slightly higher than expected. This is partly because of the more rapid pass-through of the earlier exchange rate depreciation into retail prices. However, with slack still present in the economy, core inflation is expected to remain close to current levels, below the midpoint of the Bank’s 1 to 3 per cent target range, through the balance of 1999. Uncertainty about inflationary pressures in the United States and the possible implications for the stance of U.S. monetary policy, as well as shifts in international investment portfolios (encouraged by improving economic conditions overseas), have resulted in significant movements in financial markets in recent weeks. In July, the U.S. dollar weakened markedly against both the yen and the euro. While the Canadian dollar was softer against its U.S. counterpart for much of the last month, it has strengthened recently, supported by Canada’s low inflation and solid economic expansion and by firmer world commodity prices. Interest rates in Canada remain below those in the United States across all maturities, although the differentials have narrowed since early July.

The authors examine the recent evolution of commodity prices. They discuss the factors behind the price declines that occurred between the summer of 1997 and the end of 1998, including the key supply factors and the drop in Asian demand caused by that region's concurrent financial and economic crisis. They then review the effects of the reduction in world commodity prices on economic activity in Canada. They point out that the depreciation of the Canadian dollar against the U.S. dollar, together with the continued strength of the U.S. economy, has partly offset the negative effects on Canadian aggregate demand.

This paper examines the implications of changes in economic behaviour for simple inflation-forecast–based monetary rules of the type currently used at two inflation-targeting central banks. Three types of changes in economic behaviour are considered, changes that are motivated by developments in monetary and fiscal policy in the 1990s: changes in monetary policy credibility, changes in […]

This commentary, completed in mid-January, discusses economic and financial developments in Canada since the publication of the November Monetary Policy Report. Conditions in world financial markets have improved since November, but the global economic environment is still uncertain. The main uncertainty centres on Japan, which remains in recession. If bank reforms and stimulative fiscal measures are effectively implemented in that country, a gradual recovery should begin there during 1999. The economic expansion in other major industrialized countries, which together account for over half of world output, is expected to remain well sustained. The U.S. economy, in particular, continues to outstrip expectations and even if it slows, as expected, will likely still operate at high levels. In Canada, indicators of domestic demand remain relatively firm, although the growth of monetary and credit aggregates has moderated. The Bank's outlook for 1999 continues to be one of ongoing economic expansion. Inflation is expected to stay in the lower half of the target range of 1 to 3 per cent. Update on 23 February 1999: The global economic environment in which Canada operates is still uncertain. In Japan, there is little sign yet that the economy is about to move out of its slump, while in Europe, the latest data point to a softening in economic activity. In sharp contrast, the U.S. economy continues to outstrip expectations, ending 1998 with growth of 5.6 per cent (annual rate) in the fourth quarter—much stronger growth than had been anticipated earlier. Despite lingering economic uncertainty, global financial markets have been much more stable compared with last autumn and do not seem to have been substantially affected by the events in Brazil. This would appear to reflect the effects of reductions in official interest rates around the world since the autumn as well as the success some emerging-market economies have had in dealing with their problems. As a result, international investors and markets seem to have a renewed sense of their ability to assess and differentiate among debtor countries as well as other borrowers. Here in Canada, even if we allow for the effects of temporary factors (such as the return to normal operations following the end of major labour disruptions), the underlying momentum of the economy is healthy. While resource-based export revenues remain weak, exports of other goods, particularly automotive products, surged in the closing months of 1998, bolstered by continued strong U.S. demand and Canada's improved competitive position. Growth in consumer spending eased through the latter part of 1998, mainly because of the effects on confidence of last autumn's financial turbulence and the end of financing incentives on automobile purchases. The reversal of these factors should have a beneficial effect on consumer demand early in 1999. Housing starts recovered in the fourth quarter, following the resolution of labour disputes, while business investment continued to expand modestly. The robust, broad-based employment gains recorded through the fourth quarter carried into January 1999. On balance, recent data suggest that real GDP increased by about 4 per cent (annual rate) in the fourth quarter—at the upper end of the range expected at the time the commentary was completed. The latest data point to core inflation fluctuating around the lower end of the inflation-control target range of 1 to 3 per cent. While upward pressure on the price level from the past exchange rate depreciation continues, the dampening effects of ongoing intense retail competition, excess supply in product markets, and restrained unit labour costs have kept overall inflation somewhat below expectations. Improved financial market conditions, coupled with the general firmness of recent domestic economic data and a slightly more favourable outlook for commodity prices, have supported a stronger Canadian dollar since completion of the commentary. Because of this, monetary conditions have tightened somewhat further since mid-January. With a measure of stability returning to global financial markets, concerns about the effects of financial volatility on consumer and business confidence in Canada have diminished. As noted in the commentary, such concerns were an important consideration for the Bank in the period following the Russian crisis, when particular emphasis had to be placed on calming financial markets. The easing of these pressures has made it possible to refocus attention on the medium-term policy objective of keeping the trend of inflation inside the target range.

The federal government and the Bank of Canada have been committed for some time to achieving and maintaining price stability as a way to foster a rising standard of living for all Canadians. To support this objective, the inflation-control target range of 1 to 3 per cent was recently extended through to the end of 2001. By then, the government and the Bank plan to announce a long-run target for monetary policy. In this article, the authors provide an overview of the most recent empirical evidence on the benefits of lower inflation. They draw on an extensive earlier survey and on work presented at two recent conferences on price stability hosted by the Bank of Canada. They find that, when inflation and tax interactions are taken into account, there are large benefits to lowering inflation. When these benefits are compared with the transitional costs associated with lowering inflation, significant positive benefits remain. However, the authors note that the extension of the inflation-control targets to the end of 2001 allows further research to ensure an operational definition of price stability that will help Canadians achieve a high standard of living.

The LVTS is an electronic network for sending and receiving large-value payments. It is expected to become operational in the first half of 1999. Major chartered banks and other large deposit-taking institutions will provide access to the system for their clients in the financial, corporate and government sectors. Canada’s LVTS exceeds world standards for risk control in large-value systems. The author explains how this is achieved through the netting, bilateral and multilateral credit limits, collateral, and loss-sharing procedures used in the event of a default, and, as a last resort, a guarantee by the Bank of Canada. The LVTS gives participating institutions certainty of settlement for their LVTS positions every day, even if one or more participants default. This greatly reduces systemic risk in the financial system. Moreover, the LVTS supports finality of payment; that is, it makes funds unconditionally and irrevocably available to the receiver. Finality is highly desirable when the amount of the payment is substantial, or when exact timing is critical. Since the LVTS will carry the great majority of the value of all payments in Canada, it should be considered the core of the national payments system.

This paper discusses the merits and shortcomings of alternative price indices used in constructing real effective exchange rate indices and examines the effects of different weighting schemes. It also compares selected measures of the real effective exchange rate in terms of their ability to explain movements in Canadian net exports and real output. The paper […]

This paper analyzes the short-run dynamic process of inflation in Canada and examines whether a systematic variation in the relationship between inflation and output can be detected over time. In the theoretical literature, different models of price-setting behaviour predict that the slope of the Phillips curve will be a function of macroeconomic conditions, implying a […]

This commentary, which was completed at the end of June, provides an account of economic and financial developments in Canada since the publication of the last Monetary Policy Report in mid-May 1998. International developments since May have increased the degree of uncertainty surrounding the outlook for the Canadian economy. While most indicators of domestic demand as well as the growth of the monetary and credit aggregates suggest continued relative buoyancy in the domestic economy, the foreign trade data bear clear evidence of the drag arising from the situation in Southeast Asia and Japan. However, with the various risks to the outlook appearing to be greater than previously thought, the Bank will continue to monitor developments carefully and constantly reassess its judgment of Canada's economic and financial situation. The core rate of inflation is expected to remain in the lower half of the 1 to 3 per cent inflation-control target range for the remainder of the year. Update 12 August 1998: The degree of uncertainty surrounding the international situation and its implications for the Canadian economy remains high. In Southeast Asia, economic activity continues to decline and financial markets remain nervous. In Japan, the latest economic data point to further weakness. In sharp contrast, the U.S. economy continues to outperform expectations, with domestic demand showing robust growth according to the latest information. As well, recent developments in Europe point to moderate economic expansion. Here in Canada, allowing for the effects of temporary factors such as layoffs associated with the strike at General Motors, the underlying momentum in the economy continues to be positive. The many cross-currents affecting the Canadian economy are evident in the data released since the commentary on recent developments was completed. In the resource sector, production and exports have been weak because of reduced demand from Asia. However, exports of other goods, particularly non-automotive manufacturing goods, have been buoyant, reflecting strong demand from the United States. In Canada, retail sales continue to rise and sales of existing homes are also growing, consistent with the pickup in the growth of household credit. At the same time, new home construction has weakened, in part because of strikes in the Greater Metropolitan Toronto area. Business investment and the growth of total business credit have also remained relatively strong. Recent information on overall investment intentions for 1998 show marked growth, consistent with the latest monthly indicators on investment in machinery and structures, but the resource and non-resource sectors are showing divergent near-term trends. The latest labour force data also point to sustained underlying growth in employment and incomes. On the whole, recent data suggest that real GDP increased by about 2 1/2 per cent (annual rate) in the second quarter, somewhat less than anticipated at the time the commentary was completed. Our current estimate is that the various strikes and other production disruptions (the largest being the spillover effects from the GM strike in the United States) lowered second-quarter real GDP growth by about 1/2 of a percentage point. Thus, in the absence of these disruptions, growth would have been closer to 3 per cent. Economic activity in Canada will continue to be affected by the GM strike and associated layoffs into the third quarter, complicating interpretation of the economic data for this period. This and the uncertainties on the external front underscore the need for continued close monitoring of economic developments. On balance, the positive elements of ongoing strength in consumer and investment spending in Canada, together with the high level of U.S. demand for our products, continue to support economic expansion at rates that will reduce unused capacity. On the inflation front, the latest information points to core inflation remaining in the lower half of the 1 to 3 per cent inflation-control target range. While the effects on the price level from exchange rate depreciation will be working to raise inflation, offsetting factors, such as excess supply in the economy and price competition from Asian producers, will keep overall inflation pressures subdued. Since completion of the commentary, monetary conditions have eased further as a result of the depreciation of the Canadian dollar. As noted in the commentary, the extent of the current international uncertainty is causing volatility in financial markets and fluctuations in monetary conditions over a wide range.

The consumer price index (CPI) is used to measure changes in the price level of consumer goods and services. As an indicator of changes in the cost of living, it is susceptible to various types of measurement biases. This article provides estimates of the size of these biases in the Canadian CPI. It concludes that the rate of increase in the CPI probably overstates the rate of increase in the cost of living by about 0.5 percentage points per year.