Weekend Economist: Injured indices

The Westpac Melbourne Institute Index of Consumer Sentiment fell by 6.8 per cent in May from 99.7 in April to 92.9 in May. The sharp fall in the index is clearly indicating an unfavourable response to the recent federal budget. This puts the index at its lowest level since August 2011, before the Reserve Bank began its recent rate
cut cycle. Since November 2011 rates have fallen from 4.75 per cent to 2.5 per cent and the index is now back below pre-rate-cut levels.

The fall of 6.8 per cent is comparable to the 7 per cent fall we saw in the Index in May 2013 (from 104.9 to 97.6). That sharp fall was also in response to the budget in that year and came despite the Reserve Bank cutting rates in the same month.

Confirmation that the budget was the key driver in both years is the response to a special question in the survey which was run in both years asking: “What impact do you expect the federal budget to have on your family finances over the next 12 months?” For 2014 the responses were: 3.1 per cent (improve); 37.7 per cent (stay the
same); 59.2 per cent (worsen). That compares with responses in 2013 of: 5.6 per cent (improve); 48.7 per cent (stay the same); and 45.6 per cent (worsen). The initial response to a budget can sometimes be an
overreaction. For example, in 2013 the index bounced back by 4.7 per cent in June. It is also true that it is not unusual for consumer sentiment to plummet at budget time. Other comparable falls were: May 2010 (–7 per cent); May 2009 (–4.3 per cent); May 2006 (–6.4 per cent); and May 1995 (–7 per cent).

As indicated by the “special question”, respondents were particularly concerned about the impact of the budget on their own finances. The sub-index tracking assessments of ‘family finances compared to a year ago’ fell by 11 per cent to its lowest level since July 2013. The sub-index tracking expectations for ‘family finances over the next 12 months” slumped 23 per cent to its lowest reading on record. There was also concern about the near term economic outlook: the sub-index tracking expectations for ‘economic conditions over the next 12 months’ fell by 14.2 per cent to its lowest level since August 2011.

In contrast, respondents seem to be signalling that the budget will assist the economy over the medium term. The sub-index tracking expectations for ‘economic conditions over the next 5 years’ was boosted by 11 per cent, while the sub-index tracking assessments of ‘whether now is a good time to buy a major household item’ rose by 3.2 per cent.

Despite the overall negative response to the budget, respondents did not expect their job prospects to deteriorate. The Westpac Melbourne Institute Index of Unemployment Expectations was largely unchanged declining from 159.1 to 158.3. Note, that a decline in unemployment expectations indicates an improvement. In contrast, attitudes towards the housing market took a tumble. The index tracking assessments of ‘whether now is a good time to buy a dwelling’ fell by 6 per cent and is now at its lowest level since November 2010, when the Reserve Bank had been lifting interest rates, and 25 per cent off its highs of September last year. This response is unlikely to be solely driven by the budget. Respondents have been lowering their confidence levels around housing for some months. Between September last year and April the Index had already fallen by 20 per cent.

This "Time to Buy" index has provided a reliable lead to developments in house prices. It leads house prices by around 6 months. The interesting aspect of this cycle compared to the previous cycle in 2009 is that sentiment generally held up until rates were increased. In this cycle, in a benign rate environment, sentiment has fallen well before any rate rise.

Our research indicates that there is a "6 month" lead relationship between sentiment and prices. The downturn in sentiment is likely to eliminate the key justification for near term rate hikes and allay any fears from the Reserve Bank that a rate cut would risk overstimulating the housing market. However, our view is that other "forces" around consumer spending; employment; and business confidence will preclude the need for further rate cuts. Sentiment around housing is particularly fragile in the major states with the index being down by around 30 per cent from September’s highs in both NSW and Victoria.

Waning confidence in the housing market is also apparent in the Index of House Price Expectations. The index fell by 9.8 per cent in May to its lowest level since January 2013. Concerns over high prices and limited affordability are likely to be the key reasons behind these trends.

The Reserve Bank board next meets on June 3. As indicated in the minutes of the May Board meeting, the RBA expects to keep rates on hold “for some time yet”. The big issue for the bank and the economy will be whether this strong reaction from consumers indicates that the recent improving trend in consumer spending is interrupted. While households have clearly reacted to some very unnerving headlines, the budget has clearly been structured to minimise its impact on the fragile recovery.

Over the first three years of the budget savings measures will only ‘take’ around 1 per cent of GDP out of the economy and only $1.7 billion (0.1 per cent of GDP) in 2014/15. The major savings are structured around the out years from 2017/18 onwards.

Over time households will recognise this strategy and it seems unlikely that the budget will derail this recovery in the face of a strong lift in household wealth (around $700bn) associated with recent house price increases; a very high household savings rate which is supporting a substantial strengthening in household balance sheets; and very low interest rates that are likely to remain in place until the second half of 2015.

Bill Evans is chief economist with Wesptac.