WEEKEND ECONOMIST: Consumer awakening

There are signs that lower interest rates may finally be starting to gain some traction with consumers. Confidence should translate into spending, but there are considerable caveats.

The Westpac-Melbourne Institute Index of Consumer Sentiment rose 7.7 per cent in February to 108.3. This is the strongest sentiment reading since December 2010, and the biggest monthly gain since September 2011. It follows an extended period in which sentiment disappointed, posting at best ‘neutral’ readings despite a 175 basis point reduction in interest rates since October 2011.

The more positive February reading suggests lower interest rates may finally be starting to gain more traction with the consumer. That said, confidence is still well below the levels recorded during the last easing cycle in 2008-09, which saw sustained readings of around 120.

February’s lift in sentiment was despite fairly mixed influences.

Surprisingly weak retail sales and dwelling approvals pointed to a weak finish to 2012. Official jobs data in the survey week showed the unemployment rate holding at 5.4 per cent in January, but the detail was (again) soft.

More likely than not, February sentiment was primarily buoyed by a strong start to the year for financial markets, the ASX200 rising 4.8 per cent between the January and February surveys and 13.8 per cent from its mid-November low. The housing market also continued to show signs of recovery (albeit not a particularly vigorous one), and news from offshore was supportive. Finally, while the Reserve Bank left interest rates unchanged in February, it signalled it was prepared to lower rates further if necessary.

Taking a look at the sentiment detail, views on the economy saw the strongest improvement. The sub-index tracking consumer expectations for "economic conditions over the next 12 months” surged 14.7 per cent, while the sub-index tracking views on "economic conditions over the next five years” rose 10.8 per cent. Both of these subindexes are now well above their long-run averages.

Consumers continue to have more mixed opinions on their own finances: the sub-index tracking assessments of "family finances vs a year ago” posted a solid 7.3 per cent rise, but it remains at a weak level; the sub-index tracking forward views on "family finances over the next 12 months” only picked up marginally (1.4 per cent). Family finances have been a major weak spot for confidence over the last two years, with persistent readings well below long-run average levels.

Consumer views on "time to buy a major household item” offered a more encouraging sign for Australia’s retailers. This sub-index rose 5.5 per cent to now be at its highest level since October 2010. Consumers also remain very positive on house and car purchases, with both indexes above their long-run average levels, despite modest falls in February. How much of this strength is a reflection of improved affordability rather than a firm intention to buy is an open question.

The February consumer sentiment report is welcome news, being the most promising sign yet that lower interest rates are starting to generate positive traction with consumers. But, as noted above, the picture on actual activity is much less convincing. Non-mining business investment is an unlikely candidate to offset the mining slowdown. And housing finance and retail sales data point to weak momentum in household-oriented sectors.

Therefore, while the improvement in sentiment is a positive, it must be sustained and flow through to actual spending if the non-mining economy is to strengthen enough to counteract the downturn in mining investment that will begin in the second half of this year.

Consumers' views on the labour market will be critical to translating improved sentiment into actual demand.

The Westpac-Melbourne Institute Unemployment Expectations Index gives the clearest read on perceived job security; as at February, job-loss fears will still intense.

In the month, the index was broadly unchanged (0.1 per cent) after declining by 6.2 per cent in January – recall, a fall in this index points to greater confidence among households regarding their employment. But, despite this recent improvement, at 145 the level of this index is currently well above the long-run average of 125, at levels typically only seen during recessions, significant downturns or periods of major structural adjustment (for example, the mid-to-late 1990s). Clearly the number of consumers who expect the unemployment rate to rise far exceeds those that expect a fall.

Latest official figures put the unemployment rate at 5.4 per cent in January, up 0.3 percentage points since January 2012. This increase is modest, particularly compared to the sharp rise in consumers' fears. However, the unemployment rate conceals significantly weaker underlying conditions as the unemployment rate is being heavily influenced by a substantial decline in the participation rate – the proportion of the working-age population working or actively seeking work.

Some of this shift reflects discouraged potential job seekers opting to stay out of the workforce altogether (for example, retiring, returning or extending time in the education system or raising families).

Other measures of labour market conditions such as growth in employment – full-time jobs in particular – and hours worked imply a much weaker environment which aligns much more closely with what consumers have been saying.

All told, the improvement in consumer sentiment still looks tentative. Without businesses supporting the economy by lifting investment and employment plans, optimism could quickly fade. Consumers could also lose confidence if the more positive tone on the global economy and the share market rally dissipate.

We continue to see a strong case for lower rates, and expect the Reserve Bank to cut rates by another 25 basis points at its March meeting.

The Reserve Bank board next meets on March 5. The February consumer sentiment reading will be an important input into policy deliberations, but should not divert the board from other evidence around the non-mining economy’s (lack of) current momentum and future prospects.

The capex investment intentions release due out on February 28 will be particularly important in determining the next decision by the bank. A disappointing capex report would significantly strengthen the case for a further rate cut, particularly given the currently benign outlook for inflation.

Bill Evans is Westpac's chief economist.

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