The fear index

Last week we received data which greatly added to our understanding of the current dynamics of the Australian household sector. Since the last Westpac-MI Consumer Sentiment Survey in January there was a 100 basis point cut in the RBA's cash rate; the cut being passed on in full by all the banks to the prime variable mortgage rate and the announcement of the $42 billion stimulus package (which included $12.7 billion in direct payments to Australian taxpayers in the June quarter).

Despite all this good news the Westpac–MI Consumer Sentiment Index fell by 4.6 per cent. Further the Index is now down by 7 per cent since September. That is despite the RBA slashing the overnight cash rate by 375 basis points since then and the Australian banks passing on cuts of 350 basis points to the prime variable mortgage rate over the same period.

The explanation for that rather perverse result is that consumers are certainly recognising the importance of these welcome policy initiatives for their current position but at the same time are very sceptical about the future. Within the Consumer Sentiment Index we have two types of questions – those on a household's assessment of their current position and those measuring their expectations. We have set up two separate indices – the current conditions index and the expectations index. Usually both indexes move in the same direction – good or bad economic news usually affects current assessments in the same direction as future assessments.

However, there are times when the indices move in opposite directions. Of most importance is when present conditions are assessed to have improved while expectations in fact deteriorate. In the three months to February the current conditions index rose by 24.7 per cent while the expectations index actually fell by 13.3 per cent. We have constructed a "fear index" which measures the difference between the quarterly growth rate in the present conditions index and the growth rate in the expectations Index. Clearly when the present conditions index rises and the expectations index falls there will be a positive read on the fear index.



Figure 1, which sets out the fear index, shows that the last observation for February 2009 is by far the largest read in the index since the survey was first compiled in 1974. This reading of the fear index is significantly higher than reads which preceded the two previous recessions (1982/83) and (1990/91). The job security index which is also measured in the consumer sentiment survey also registered its highest ever read – see Figure 2.



With households in such a fearful mood, significantly driven by their job concerns, there is little doubt that they will be aiming to restore their balance sheets and increase savings. This was very clear in December, when households received $8.4 billion in government payments but retail sales increased by "only" $700 million. Further we have seen a sharp reversal in equity withdrawal as households move quickly to pay down debt.

With this fear index at record levels it seems likely that further payments to the sector including tax cuts will be largely saved. That however is not wasted policy since it will assist households to lower debt putting them in a stronger position to deal with future developments. All else equal the downturn associated with a further possible negative shock will be moderated.

The latest read of the consumer sentiment index also contained some welcome news. There was a 7 per cent increase in the Index measuring whether now is a good time to buy a house. That index is now at its highest level since December 2001 indicating that some recovery can be expected in the housing market. That signal was confirmed when finance approvals surged by 6.4 per cent in December, including a 10 per cent increase in lending for new home construction. Our statistical work based on the rise in the sentiment Index is pointing to a solid increase in new borrowing. However growth in the stock of housing credit, which is dominated by existing borrowers, will stagnate as these borrowers seek to reduce debt.

Bill Evans is Westpac's global head of economics