WEEKEND ECONOMIST: Rate cut revised

The results of the Westpac-Melbourne Institute surveys, which were released this week, emphasise the current risks to the Australian economy, particularly around the economy and the labour market, .

The Westpac–Melbourne Institute index of consumer sentiment fell by five per cent in March, from 101.1 in February to 96.1 in March. The index has now fallen below the level in October last year, prior to the Reserve Bank's two rate cuts in November and December. When the Index is below the 100 level, pessimists clearly outnumber optimists.

Sensitivity to interest rates has clearly been one factor responsible for this weak print. The survey in February closed off before it was announced that banks were raising their mortgage rates, despite the Reserve Bank having kept the official cash rate on hold. Recall that the survey in February covered the week of the Reserve Bank's Board meeting. At the beginning of the week, media reports had led respondents to confidently expect a 0.25 per cent rate cut from the Reserve Bank.

With the two previous rate cuts in November and December being passed on in full by the banks, it is reasonable to assume that many borrowers expected a further cut in the mortgage rate of 0.25 per cent. Instead, mortgage rates were actually increased in the following week with banks raising mortgage rates by an average of 0.10 per cent. It is likely that this reversal has impacted confidence.

This ‘rate effect' is consistent with the 6.8 per cent fall in the confidence of those folks who have a mortgage. However, this observation does not explain why there was a 10.8 per cent fall in the confidence of respondents who are renting accommodation. There are other forces at work. Petrol prices, for example, rose three per cent between the February and March survey to an average of around $1.45 a litre. However, our supplementary questions indicate that respondents are particularly concerned about economic conditions and employment.

In the March survey, we also measure the ‘news' categories that are most recalled by respondents and whether these categories are assessed to be favourable or unfavourable. The most recalled news categories were: ‘economic conditions' (56.4 per cent of respondents); ‘international conditions' (30.9 per cent); ‘Budget and taxation' (28 per cent); ‘interest rates' (24.5 per cent); and ‘employment' (16.6 per cent). These proportions are near historical highs for ‘economic conditions‘ and ‘employment'. The measures of ‘favourability' for both ‘economic conditions' and ‘employment' were near the lows registered in the 2008/09 and 2001/02 periods.

Relative to December, respondents were marginally more positive about international conditions, but much more concerned about employment and interest rates. Concerns about economic conditions, which increased sharply in December, remained very high in March. Recent data releases showing weak growth in GDP in the December quarter and a rise in the unemployment rate for February are likely to have exacerbated respondents' concerns, as would the sharp fall in company profits reported for the final quarter of 2011.

Amongst the sub indices of the index, we have found that how respondents assess their own finances is particularly significant for spending plans. This sub-index fell by 6.3 per cent, the sharpest fall since June 2010.

Households' concerns about job security also intensified in March. The Westpac–MI unemployment expectations index jumped by 4.2 per cent in March. The index is now up 41 per cent over the last year, indicating that respondents are significantly more concerned about job prospects. It is at its highest level since July 2009 and only around 10 per cent below the average level over that prior nine-month period, when households registered record degrees of anxiety about jobs in the aftermath of the global financial crisis.

Recall that during that period, the policy response was swift and aggressive. The Reserve Bank reduced the overnight cash rate by 4.25 per cent and fiscal policy was eased by six per cent of GDP over two years. Today, fiscal policy is expected to be tightened by 2.7 per cent of GDP and the rhetoric of the Reserve Bank does not imbue this writer with any confidence that rate cuts are being contemplated in the near term. Indeed, based on the banks' actions in February, any move by the RBA might result in less effective policy easing than expected from the direct rate cut.

This unemployment expectations index has a reliable track record in leading movements in the unemployment rate. It is consistent with our forecast that the unemployment rate is likely to rise in excess of 5.5 per cent, reaching 5.7 per cent by the second half of 2012. Recall that the unemployment rate peaked at 5.87 per cent in July 2009 and quickly fell in response to strong policy easing. The question remains as to how far the unemployment rate might increase in the absence of any policy response.

We expect that the labour market holds the key to future policy. The Reserve Bank will need to see a further deterioration in the unemployment rate, possibly to as high as 5.4–5.5 per cent , before it decides to ease policy. For that reason, we are not anticipating a rate cut in April, but retain our expectation that the next move will be in May or June.

Bill Evans is Westpac's chief economist.