The most important graph from the Bank of Canada’s Monetary Policy Report (pdf):


The shift in the terms of trade plays a leading role in the story of the the Canadian macroeconomy over the past five years. Deputy Governor Pierre Duguay’s speech last August puts it this way:

"The substantial rise in real commodity prices since the beginning of
2003 and the reduced prices for imported consumer goods from
emerging-market economies have resulted in a significant improvement in
our terms of trade, and generated large gains in real income.These gains, which are reflected in higher prices for domestic output
relative to those for domestic purchases, account for 1.6 percentage
points of the 3.6 per cent annual growth in real income since 2002…

[T]he sharp rise in the exchange rate has signalled the need for prompt
adjustment. It has intensified the pressure on many manufacturers, who
were already facing stiff competition from producers in emerging-market
countries. It has reduced their export revenues and lowered the prices
of competing imports, even as the prices of many raw material inputs
were rising…

With profitability especially strong in the energy and mining
sectors, as well as in most sectors with low exposure to international
trade, businesses and investors have been quick to seize the new
opportunities presented by the improvement in our terms of trade. We’ve
seen strong growth in capital spending and employment in these sectors.
A surge in investment in machinery and equipment across the economy
suggests that firms are taking advantage of the stronger exchange rate
(which reduces the cost of imported machinery and equipment) to improve
their productivity and enhance their competitiveness. Many
manufacturers are taking advantage of lower-cost imported inputs or
shifting their focus to higher-value-added production.

Labour is also adjusting to the terms-of-trade shock. The evidence
shows that labour markets in Canada are relatively flexible, which
helps the country adjust to labour-demand shocks. While employment has decreased markedly in manufacturing since 2004, it
has grown strongly in non-farm primary industries, in construction, and
in other sectors that are driven by the strength in domestic demand—for
example, finance, insurance, real estate, and health and education
services. These developments have involved a sharp increase in net
migration of labour to Alberta from other parts of the country.
Employment growth in Ontario and Quebec has moderated a bit, but still
averaged a relatively robust 1.3 per cent from July 2004 to July 2006.

Overall, the Canadian economy has been adjusting rather well, though
not without pain, to a significant change in economic circumstances."

That’s not to say the Bank is getting complacent:

"The Bank’s interest in understanding how terms-of-trade movements
play out in the economy is not new. For decades, the Bank of Canada has
monitored the effect of swings in the terms of trade on real income and
on the external value of the Canadian dollar. Over the years, we have
built models to study how changes in the terms of trade and the
subsequent economic adjustment affect the economy. But it is only recently that Bank staff have formally incorporated a
separate commodity sector into our main projection model, ToTEM.

In contrast to the Bank’s previous model, which treated economic activity as a single aggregate, ToTEM—which stands for Terms of Trade Economic Model—makes explicit the
distinction between raw materials or commodities, and manufactured
goods. This distinction is crucial for two reasons. First, commodity
production represents a sizable proportion, some 11 per cent, of
Canadian GDP, and commodity exports account for nearly 45 per cent of the dollar
value of our total exports. Second, the commodity sector and the
manufacturing sector are characterized by different technologies and
different competitive structures, which have important implications for
the behaviour of inflation. For instance, the production of commodities
is more capital-intensive and more price-inelastic than the production
of other goods and services. Moreover, commodity prices are set in
world markets, whereas manufactured goods are subject to product
differentiation and to a greater degree of price-setting influence by
firms.

In ToTEM, the key driver of consumer prices is the marginal cost of
producing consumer goods. Consumer goods are produced using four
inputs: labour, capital, an imported intermediate good, and
commodities. In this framework, the marginal cost can be expressed as a
function of labour costs (including the costs of hiring and training),
as well as the price of imported intermediate goods, the price of
commodity inputs, the price of investment goods, and the rate of
capacity utilization.

ToTEM is a clear improvement over the previous model in its ability
to capture the response of the Canadian economy and the Canadian dollar
to changes in commodity prices. That’s all I’ll say about ToTEM for
now. But this fall we’ll be publishing an article in the Bank of Canada Review that will discuss this new model in some detail."

The Bank’s decision-makers must have decided that they didn’t want to keep making policy with a model in which the most important macro development over the past five years played only a peripheral role.