WEEKEND ECONOMIST: No pain yet

Following the release of the Westpac MI Consumer Sentiment Index we confirmed our forecast that the RBA would resume tightening rates in February with a fourth 25 basis point rate hike. We were concerned that the level of rates might have reached a level whereby Sentiment became very sensitive to rate hikes.

The 3.8 per cent fall is surprisingly modest given recent developments on interest rates. On December 1, the Reserve Bank raised the overnight cash rate by 25 basis points for an unprecedented third consecutive month and most banks increased their variable mortgage rates by more than the 25 basis points. The standard variable mortgage rate has now increased to between 6.5 per cent and 6.75 per cent compared to around 5.75 per cent as recently as September. Over that period the Index has fallen by 4.7 per cent from its near record highs.

We expected that there was a real possibility that the Index would fall much more sharply than the 3.8 per cent which it has registered. Note that after the RBA tightened by 25 basis points in March 2005 the variable mortgage rate was increased to 7.3 per cent from 7.05 per cent and the Index fell by a massive 15.5 per cent.

Each subsequent increase in mortgage rates over the course of 2006 and 2007 generally saw "double digit” falls in the Index. With households now holding even more debt relative to their incomes we expect that we must be getting close to levels of the variable mortgage rate where households will become much more sensitive than is currently the case.

A closer inspection of the components of the Index shows that those folks holding a mortgage have responded much more negatively to the rate increases than those who are not holding a mortgage. Confidence amongst those with a mortgage fell by 8.9 per cent while confidence of those who are renting actually increased by 1.6 per cent while those wholly owning their homes registered a fall of 4.1 per cent.

Other positive factors are clearly supporting the confidence of those households who are not borrowers. The share market rose by 2.4 per cent; the Australian dollar was slightly higher; and petrol prices were broadly stable (up by 0.7 per cent). However, encouraging news on the labour market was probably the most important offset to the news on interest rates. Following the stunning increase of 40,000 jobs in September it was reported that a further 25,000 new jobs had been created in November despite market forecasts for job losses. Supporting this view was the "News Heard Index” which, surprisingly, showed that more households recalled news on the state of the economy than on interest rates.

Their assessment of the news on interest rates was decidedly pessimistic but the assessment of news stories on the economy was still comparatively upbeat.

All components of the Index fell in December although the assessment of current conditions (down by 2.1 per cent) was more resilient than "expectations" (down 4.9 per cent)”. Responses on "family finances compared to a year ago” (down 1.9 per cent); "whether now is a good time to buy a major household item” (down 2.3 per cent) and "the five year economic outlook" (down 1.4 per cent) were all quite modest falls. Households are more concerned about the near term. Responses on "family finances over the next 12 months” (down 6 per cent) and "economic conditions over the next 12 months” (down 7.2 per cent) were both much weaker.

However, retailers should derive considerable comfort from the relatively modest fall of only 2.3 per cent in the "time to buy a major household item” component.

The run of interest rate increases has clearly affected Sentiment towards housing with the "time to buy a dwelling” index down by a relatively modest 12.3 per cent since September although, surprisingly, the index actually increased by 2.5 per cent over the month. For households it appears that optimism about house prices may be offsetting any concerns about interest rates as far as housing is concerned. This broader optimism is supported by the 2.9 per cent increase in households’ sentiment towards purchasing a motor vehicle over the month.

With rising deposit interest rates, banks have increased their attraction to savers. The proportion of those respondents nominating banks as the wisest place for savings increased from 26.7 per cent to 29 per cent. This increase is likely to reflect higher rates rather than risk aversion.

The proportion of households indicating that the wisest place for savings is to pay down debt fell from 25.5 per cent in September to 20.7 per cent in December. Real estate preferences increased from 15.6 per cent to 18.5 per cent also supporting the view that rising house price expectations are offsetting the impact of higher interest rates.

The Reserve Bank board does not meet again until February 2. The Governor’s last Statement indicated that the Board would most likely have paused if there had been a meeting in January. With no meeting scheduled for January it appears likely that the Bank will opt to raise the overnight cash rate by 25 basis points on a fourth occasion in February.

The evidence from this survey is that households overall are coping relatively well with the interest rate increases to date. Optimism about house prices and jobs are partially offsetting the impact of rate hikes on Consumer Sentiment. We have little doubt that we are nearing a point where the level of the variable mortgage rate will start to elicit a much more negative response across all households but the evidence from this survey is that we are not there yet.

The employment report which was released on the following day was a stunner and will ensure that consumers maintain their confidence about job prospects. While markets were expecting a modest 5,000 jobs increase we saw 31,200 new jobs for November (30,800 full time jobs) and the unemployment rate fall to 5.7 per cent.

It appears to us that markets have reacted quite conservatively to the Consumer Sentiment and employment data with the probability of a 25 basis point rate hike in February increasing from 40 per cent (after the CSI release) to 60 per cent (after the employment data release).

It may be that markets are apprehensive about the release of the September quarter GDP next week.

Certainly the traditional way of estimating the GDP result is currently revealing a curious result. Confidence measures and the jobs story are not consistent with an economy that actually contracted. Recall that the GDP print is the average of three separate measures of GDP. These are GDP (expenditure), GDP (incomes) and GDP (production).

Through the year to the June quarter GDP (E) grew by 2.9 per cent; GDP (I) contracted by 0.4 per cent and GDP (P) contracted by 0.7 per cent. The "average" of these three components is 0.6 per cent and the "official" growth rate for the Australian economy over the year to the June quarter is 0.6 per cent.

Typically markets think about growth in terms of GDP (E) since that is the measure that is derived from the expenditure side of the economy being built up from consumption; housing and business investment; government spending; inventories and net exports. Most of the partial data which is released through the quarter provides a guide for GDP (E).

For the September quarter the GDP (E) story looks negative. We expect consumption growth (zero); business investment growth (-4 per cent) and net exports (subtracting 1.8 percentage points from growth) will all be huge headwinds for GDP (E). That will be partially offset by government spending growth (up 3.5 per cent); dwelling construction growth (up 3 per cent) and inventories (adding 1.9 percentage points to growth in GDP (E)).

Overall we would look to GDP (E) to contract by 0.1 per cent. However we are forecasting overall GDP growth of 0.4 per cent on the basis that the other two measures play some "catch up" with GDP (E). Average growth of 0.65 per cent in GDP (I) and GDP (P) will deliver the 0.4 per cent forecast.

The sharply negative prints on GDP (P) and GDP (I) appear to have passed with the easing of the global crisis and inventory rundown. The June quarter saw both measures print 0.6 per cent and it is reasonable to expect that the huge gap in growth rates between the three components can close further in the September quarter. Our estimate would see the annual growth rate gaps close to GDP (E) of 2.1 per cent and GDP (I) of 0.45 per cent and GDP (P) of minus 0.45 per cent. Overall annual GDP growth would be 0.7 per cent.

Another possibility is that significant revisions to history go some way to narrowing the gap between the three estimates of GDP.

As readers will detect the extraordinary discrepancies between the three measures of GDP make this forecast particularly difficult. However it is very unlikely that a "surprise" GDP result would move markets. The outlook for growth in 2010 is strong driven by confidence and partial indicators. The September quarter GDP print – even if it is a modest negative is unlikely to change that outlook.

Bill Evans is chief economist at Westpac