Reflections on October 6, 1979, and Its Aftermath

Abstract

The Bank of Canada was facing problems similar, but not identical, to those facing the Fed in 1979. Following the adoption of targets for the monetary aggregate M1 in November 1975, inflation (as measured by the 12-month increase in the consumer price index [CPI] excluding food and energy) had decelerated from about 9 percent in the second half of 1975 to a low of about 51/2 percent in mid-1978. This reflected policies aimed at a gradual disinflation: monetary policy through a reduction in M1 growth from 1975 on and wage and price controls over the 1975-78 period. Subsequently, there was a marked intensification of inflationary pressures in the Canadian economy from both external factors (the rise in commodity prices and U.S. inflation) and internal factors (the pressure of demand in the Canadian economy), in spite of the continued deceleration of M1. Inflation increased to about 8 percent by mid1979. At the time, a lot of emphasis for the rise in inflation was placed on special factors, especially the exit from wage and price controls and the effects of the renewed rise in oil prices related to the revolution in Iran in early 1979. In retrospect, an important part of the explanation for the divergence of the path of inflation growth from that of M1 growth was the high interest rate elasticity of the demand for M1.1 This meant that, when M1 growth tended to rise above target as a result of an increase in price inflation, the rise in interest rates needed to keep M1 on target was INTRODUCTION C anada is the quintessential “small open economy.” It has very close ties with the United States in both trade and capital movements. On the financial side, interest rate movements in the United States can affect Canada fairly quickly through their influence on the exchange rate and on domestic interest rates. As a result, economic and financial developments in the United States have an important influence on the Canadian economy and on policymaking in Canada. The changes in the Federal Reserve operating procedures of October 6, 1979, and the subsequent wide fluctuations in short-term and longterm U.S. interest rates had significant effects on interest rate and exchange rate developments in Canada and thereby on Canadian monetary policy. This paper examines a variety of issues related to these developments. The next section of the paper sets out the background to the Canadian economic situation in the latter part of the 1970s. In the following section, I examine the analyses carried out in the Bank of Canada in response to the announcement of October 6, focusing particularly on the analysis of the new operating procedures announced on that date. The subsequent section of the paper looks at the effects of the change in the U.S. policy framework and of the resulting U.S. interest rate movements on Canadian financial developments and on the way they affected policymaking in Canada. A final section offers some concluding remarks. 1 There may also have been insufficient adjustment for the downward shift in M1 in response to financial innovations when the targets were rebased.