The Reserve Bank Board Minutes for the August 4 meeting confirmed most clearly that the Bank has moved to a tightening bias – rate hikes were openly discussed, as shown by this comment: "In discussing the timing and process of removing some of the current expansionary policy setting". The conclusion to the discussion was summarised with: "There was a risk of overstaying a very accommodative setting in a recovering economy...on the other hand there was a risk of an early tightening choking off confidence and demand prematurely."
The recent extraordinary surge in both business and consumer confidence has probably been the most significant development in leading to such a sharp reversal in the Bank's own sentiment.
Recall that the Minutes of the previous meeting on July 4 still included, "members noted that the current inflation outlook afforded scope for some further easing of monetary policy."
The chart below shows the extraordinary rise in both business and consumer confidence over the last three months. Both business and consumer confidence have now recovered to the highest levels since the September quarter in 2007. The increase in the Westpac Consumer Sentiment Index over the last three months (27.7 per cent) has been the largest increase over three months since we first started measuring the Index in the mid 1970's.
The significance of this rise in Consumer Sentiment is demonstrated in the next chart. If Sentiment were to hold around current levels for an extended period then we could expect growth in consumer spending through 2010 of around 5 per cent rather than the 2.5 per cent we are currently expecting. Five per cent growth in consumer spending would be consistent with the Australian economy growing above trend and certainly not be consistent with "generational lows" in interest rates.
However, Sentiment is unlikely to hold at current levels. The component of the Index which captures consumers' assessments of the economic outlook over the next five years is at its highest level since the Survey began in 1976 and this component of the Index is 9 per cent higher than its level when the overall Index reached its record high in May 2007. There are too many uncertainties facing the domestic and global economies to sustain such optimism about the long term.
Excessive government debt globally; uncertainties about the state of the global financial system; questions about the sustainability of China's current growth "miracle"; uncertainties about the interaction between fiscal authorities who may try to ease the strain on their balance sheets by extracting an inflation tax; and monetary authorities who will aim to contain inflationary expectations are just some of the huge questions affecting the medium term outlook. It seems almost surreal that Australian consumers could be at record levels of optimism about the medium term.
The more immediate question is how confidence will respond to the sharp turnaround in the stance of the Reserve Bank. As discussed above, only last month the Bank was indicating an easing bias – now it has a tightening bias.
In previous tightening cycles confidence has generally been reasonably resilient in the early stages of the cycle. There is no historical support for my prior thought that once rates start to rise, expectations will be very adversely affected, despite rates still being very low in the early stages of the cycle.
We have three previous rate hike cycles to consider.
In the first hike cycle in the August-December 1994 period, the cash rate started the cycle at 4.75 per cent and was increased by 75 basis points and 100 basis points in the first two moves in August and October 1994. Over that period, sentiment only fell by around 2.5 per cent per month. Some feared that rates would return to the 17 per cent of 1990 and confidence suffered. The third and final 100 basis point move was devastating for consumers. Sentiment collapsed by a further 9.1 per cent and while markets (and senior executives at the Reserve Bank) initially feared that rates would have to go much higher that jolt to confidence, the subsequent wind back in consumer spending meant that rates peaked and were not set to rise again until November 1999.
The Consumer Sentiment Index was the first and clearest indicator that monetary policy had done its job. Of course, during that period household debt to income ratios were around 60-65 per cent so the move from 4.75 per cent to 6.5 per cent was much less painful than it would be today, when debt to income ratios are around 160 per cent (see below chart). Nevertheless, the move in the cash rate from 6.5 per cent to 7.5 per cent (8.75 per cent variable mortgage rate) proved to be the "tipping point.", rather than the early moves in the cycle.
The second tightening cycle began in November 1999 when the cash rate was increased by 25 basis point's from 4.75 per cent to 5 per cent. There was no change in sentiment but when rates were increased by 50 basis point's in February 2000 confidence crashed by 6.8 per cent. Three subsequent increases of 25 basis points each over the April-August period saw a further 17 per cent fall in confidence. although this a more difficult period to analyse because it spans the introduction of the GST and many factors would have been affecting confidence at the time. By this time debt to income ratios had risen further to 95 per cent which is broadly consistent with a lower "tipping point" – this time a cash rate of 5.5 per cent (7.3 per cent variable mortgage rate) compared to the 7.5 per cent (8.75 per cent variable mortgage rate) in the previous cycle.
The most recent cycle was a long six-year tightening cycle. The cycle began in May 2002 with a 25 basis point rise in the cash from 4.25 per cent with no significant impact on confidence. Confidence was equally resilient to a further 25 basis point move in June. Due to major global shocks associated with the aftermath of the burst of the dot com bubble (Enron; Worldcom) the Bank desisted from any further moves until November-December 2003, when two consecutive 25 basis point increases to push the cash rate to 5.25 per cent (7.05 per cent variable mortgage rate) lowered sentiment by 5.5 per cent with a particularly negative impact on the housing market. Sydney house prices fell by 10 per cent over the next year and new housing loan approvals collapsed by 25 per cent. This time, debt to income ratios had further increased to 135 per cent.
Over the next three years the RBA raised the cash rate by a further 200 basis points in 25 basis point increments, with the impact on sentiment being consistently dramatic. The average fall in Sentiment following a rate hike over that period was 9.3 per cent with the largest being 16.2 per cent following the move in August 2006. Over that period the debt to income ratio increased further from 135 per cent to 160 per cent. It appears that once the variable mortgage rate exceeded 7 per cent the sensitivity of consumers to rate hikes was extremely high.
In summary, the impact of rate hikes on sentiment was muted in the early stages of the cycle. Consistent with the sharp rise in debt to income ratios the "tipping point" of the variable mortgage rate at which rate hikes really affected sentiment fell from 8.75 per cent in 1994 to 7 per cent in 2003, when the debt to income ratio had risen from 65 per cent to 135 per cent. With the rise in the debt to income ratio and as the variable mortgage rate moved further above 7 per cent the impact of rate hikes on sentiment was substantial.
In the "new" tightening cycle, the RBA will be starting with a variable mortgage rate of 5.8 per cent – well below the "tipping point" of previous rate hike cycles when sentiment started to be affected. Of course, that "tipping point" will be lower than the previous 7 per cent, since the debt to income ratio has risen from the 135 per cent to 160 per cent, but certainly appears to be higher than the current 5.8 per cent.
We cannot be sure of the level of the new "tipping point". One crude way to assess this is to adjust the previous "tipping point" interest rates for the debt to income ratio operating at the time to get a debt service ratio "tipping point". In 1995 that was 5.7 per cent (8.75 per cent x 0.65); 6.9 per cent in 2001 (7.3 per cent x 0.95); and 9.5 per cent in 2003 (7.05 per cent x 1.35).
At current variable mortgage rates the current debt service ratio is 9.3 per cent ( 5.8 per cent x 1.60) – around the same level as the 2003 debt service ratio "tipping point". That would imply that sentiment will start to fall sharply with the first increase in the mortgage rate.
However, the existence of extensive mortgage discounting and the apparent upward trend in the debt service "tipping point" probably indicates that sentiment will be resilient in the early stages of the next rate hike cycle.
Current sentiment levels are consistent with a much faster rebound in economic growth than we expect to be the case. There are good reasons to expect sentiment to weaken in the second half of 2009.
We expect the RBA to begin raising rates from February next year. Our analysis of previous tightening cycles indicates there is some evidence to suggest that in the early stages of the tightening cycle sentiment will be reasonably resilient. However, there will be a point of the cycle after which Sentiment will weaken sharply.
Depending on what else is happening in the economy, that will be the first sign that rate hikes will be starting to bite. On face value, it appears that the Bank will have some scope to raise rates back to more normal levels before it starts to sharply disturb sentiment. Because of the high level of uncertainty about this "tipping point" level the Bank is likely to stick with previous policy in tightening cycles of moving in 25 basis point increments. The first 100 basis point's of rate hikes which we expect for next year are likely to have a manageable impact on sentiment.
Bill Evans is chief economist at Westpac.
WEEKEND ECONOMIST: How strong is sentiment?
The surprising strength of consumer and business confidence has forced the RBA to consider raising rates much earlier than many expected. But will sentiment remain resilient in the face of economic problems and the prospect or rising rates?
Want access to our latest research and new buy ideas?
Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.Sign up for free