WEEKEND ECONOMIST: Confused consumers?

The Westpac–Melbourne Institute Index of Consumer Sentiment rose by 5.4 per cent in August from 113.1 in July to 119.2 in August. This was a very strong result.

After tumbling by 15 per cent in the wake of three consecutive rate hikes in March, April and May the index has recovered by 17 cent in the last two months. It is now back to around the level it reached at the beginning of this year and the level we saw prior to the beginning of the rate hike cycle in September last year.

There were many reasons to expect the index to rise in August, although a 5.4 per cent increase following the 11.1 per cent increase last month is much larger than we had expected. Clearly the most important
factor was the decision by the Reserve Bank to keep its overnight cash rate steady in August.

There had been intense media speculation about a rate hike and we certainly assessed that a likely high read for inflation in the June quarter would have resulted in a rate hike. In the event the inflation report printed a surprisingly low number which allowed the Reserve Bank to avoid a rate hike.

The significance of the rate decision can be seen with the 10.2 per cent increase in the confidence of those folks who hold a mortgage compared to a 0.9 per cent reduction in the confidence of those respondents who wholly own their property. However, confidence amongst people who rent was also up by 10.2 per cent, so other factors were also at work.

News on the labour market was strong. A total of 45,900 new jobs were added for June and the unemployment rate held at a low 5.1 per cent. Petrol prices fell by 2.6 per cent, the Australian dollar rose by 4.6 per cent
against the US dollar, and the Australian sharemarket was up by 3.9 per cent.

Uncertainty over the election result, which may have contributed to a surprise fall in business confidence, does not appear to be affecting households. All components of the Consumer Sentiment Index increased in
August. The assessment of family finances versus a year ago rose a further 5.7 per cent after rebounding sharply in July from a June slump.

Expectations for family finances over the next 12 months also posted a solid 6.1 per cent rise. Sentiment on the economic outlook – which has been notably stronger than views on family finances in recent
months – also improved in August with an 8.6 per cent rise in expectations for the next 12 months probably reflecting the reduced threat of follow-on interest rate rises this year.

Most notably, consumers' opinions on "whether now is a good time to buy major household items" also posted a solid 3.5 per cent rise with this component index now at its highest level since July 2007.

Ordinarily, this could be expected to translate into a strong pick-up in consumer spending and retail sales. But as we have seen over the last year, high levels of consumer confidence don't always result in stronger spending. While sentiment hit historical highs in late 2009 and early 2010, spending – retail spending in particular – has stagnated, barely rising in per capita terms.

The detail to the Consumer Sentiment Index provides some explanation of the sub-par spending and hints that the latest revival may be more 'demand-rich' for retailers. The Index is a simple average of responses to five questions: two on family finances (versus a year ago, and outlook for year ahead); two 'economic' questions (outlook for year ahead and for five years ahead); and one on whether now is a good time to buy a major
household item.

The survey also includes additional questions on whether now is a good time to buy a vehicle, a dwelling, and, every quarter, on the wisest place for savings. Westpac has used responses to this last question to compile a measure of 'risk aversion' based on the proportion nominating 'safe' places (pay down debt, interest bearing deposits etc) versus those nominating riskier asset classes (real estate and shares).

Several things show through in the detail. Firstly, the elevated level of headline sentiment has mainly been due to strongly positive assessments of economic prospects. Responses to questions on family finances and 'time to buy a major household item' have been weaker and slower to recover, implying lingering budgetary pressures from the 2008-09 slowdown.

Secondly, the responses on 'wisest place for savings' have shown a sharp deviation since 2007, indicating a much more conservative approach to finances: the much talked about 'consumer caution' that has been inhibiting, amongst other things, retail spending. Indeed, if we redefine consumer sentiment as the average of 'non-economic' questions and our risk-aversion index, it shows a much closer fit to recent trends in actual
retail spending.

Thirdly, and perhaps most importantly, the last three months hints at some lifting in these components. If this continues, it suggests the latest rally in sentiment may deliver more lift in actual spending. It could yet be a reasonable Christmas for Australian retailers.

The Board of the Reserve Bank next meets on September 7. We expect that rates will again remain unchanged. With inflation pressures having subsided; activity in housing and retail remaining subdued and uncertainties in the world economy persisting the bank is likely to hold steady.

This situation should persist for the remainder of this year. However this survey is an early signal that the effects of the series of rate hikes on households may be starting to wane. Further, our risk aversion index is also sending a more encouraging message for spending over the second half of 2010.

In the absence of any major new disturbances from the global economy the prospect of steady rates and lower risk aversion from consumers should start to see a firming of housing and consumer spending through the second half of 2010. By 2011, a more confident consumer; improving housing market and a lower unemployment rate should see a resumption of the tightening cycle.