WEEKEND ECONOMIST: Confidence key

Australia is on the brink of a growth transition – from mining to interest rate sensitive parts of the economy. It will be a difficult process made moreso by the nation's fragile state of mind.

As we have discussed before on these pages the central theme around monetary policy in 2013 revolves around the assessment by the Reserve Bank that the economy needs to transition from the boost which the mining sector is giving growth to the interest rate sensitive parts of the economy.

Mining investment is likely to add around 2 percentage points to GDP growth in 2012 but subtract around 1 percentage point from growth in 2014. In turn, improved contributions from housing and consumer spending will need to be complemented with increased business investment in the non-mining sectors of the economy.

The rebalancing is planned to be catalysed by a boost to house prices and construction in response to an extended period of low interest rates. Construction activity and rising confidence is likely to boost job growth which will in turn boost incomes and spending. Reflecting improved activity in the housing/consumer sectors firms are expected to raise investment and broader employment plans that will assist in supporting growth and the rebalancing of the economy.

Recent developments in both consumer and business confidence highlight the challenge of engineering this transition without any hiccups. The Westpac Melbourne Institute Index of Consumer Sentiment fell by 4.1 per cent in December to 100 exactly from 104.3 in November. That was an unexpected result. When we saw the 5 per cent increase in the Index in November – despite the Reserve Bank surprisingly holding rates steady on Melbourne Cup day – it appeared that sentiment was finally starting to respond to the series of rate cuts that had accumulated since November last year. With that assessment in mind it was therefore reasonable to expect that the Index would respond quite positively to the cut which the Reserve Bank delivered on December 4.

The reality is that the index fell back to near its October level and is now 3.2 per cent below the November level in 2011. Households with a mortgage did respond positively to the rate cut, with their confidence rising by 4.4 per cent. However, other respondents were very downbeat. Confidence among tenants and those who wholly own their home fell by 9.1 per cent and 10.9 per cent respectively. Respondents remained quite negative around economic conditions, international conditions and employment. Apparently the fall in headline unemployment rate from 5.4 per cent to 5.2 per cent which was announced during the survey period had a limited impact on respondents.

Perhaps the most plausible explanation for households' reticence to fully embrace the low rates are their ongoing concerns around job security. The Westpac-Melbourne Institute unemployment expectations index rose 8.6 per cent (assessments of job security deteriorated) in December almost fully unwinding the 8.4 per cent fall in the previous two months. The index is now up 10.4 per cent over the past year. The current level of the index is 23 per cent higher than its long run average. The current level of unemployment expectations point to a further rise in unemployment through 2013. Of course were it not for a decline in the participation rate the rise in unemployment would have been in line with expectations. This result highlights the importance of the business sectors' confidence. Decisions to invest and employ will be crucial for growth in 2013.

In a more encouraging sign for the housing market the rate cut has further boosted confidence around whether ‘now is a good time to purchase a house’ with sentiment improving by a further 1.9 per cent to reach its highest level since September 2009 (recalling that in 2009 house prices increased by 15 per cent in Australia and those increases were a major factor behind the Reserve Bank’s decision to begin the rate hike cycle in October 2009). However, in contrast to 2009 when the Bank was seeking to "make room” for the mining boom in this cycle they will be seeking to support a housing recovery as a central goal.

To compound this weakening in household psychology we also witnessed a very weak December result on business confidence and conditions. The NAB business survey (conducted ahead of the Reserve Bank’s December rate cut decision) painted a bleak picture, particularly with regards to profitability. There was confirmation of persistent weakness in business conditions. The business conditions index was unchanged at a reading of -5. This is well below the historic average of 1. The confidence index fell sharply, down 8 points to -9. This is materially below the historic average for this series of 6. The only positive is that this reading is currently well above the record lows touched during the 2008-09 period. The plunge in business confidence has taken the index to its weakest level since April 2009, when global trade had been recovering for a few months.

Factors affecting business confidence will include the level of the Australian dollar and political uncertainty. With next year being an election year political uncertainty can only expect to heighten. Investment and employment decisions might be delayed until more political certainty is established. The decision by the US Federal Reserve to adjust its quantitative easing program from switching from short to long bonds to outright purchase of long bonds ($US45 billion per month) has already had a meaningful impact on the Australian dollar – having nearly touched $US1.06 on December 13.

The objective of the Fed is to reduce the availability of government bonds in the expectation that investors will purchase higher risk assets with a higher growth multiplier. Effectively this liquidity also crosses borders to higher yielding currencies such as the Australian dollar. That process also assists the US economy by making the US dollar more competitive although of course comes at the competitive cost to the other countries. With the Reserve Bank nominating the high Australian dollar as one motivation behind its decision to cut rates in December this latest development with the Australian dollar will be most unwelcome.

The Reserve Bank board next meets on February 5. For some time it has been our expectation that the board will decide to cut rates again in the March quarter. These latest updates on Consumer and Business Confidence strongly support that case. Despite another rate cut and some improving sentiment towards housing, consumers remain cautious and particularly concerned about the outlook for the economy and employment. Businesses appear to be losing confidence, pointing to a potential "hole” in business investment and hiring in the near term.

The Reserve Bank has two more months to assess the impact on the economy of this extended period of low interest rates. Evidence to date is that low rates are not achieving traction with the hearts and minds of households or business. It is unlikely that a central bank would concede that its primary policy instrument is ineffective. Hence the Reserve board is likely to decide to ease rates further in February, or, at the latest, March.

Bill Evans is Westpac's chief economist.

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