WEEKEND ECONOMIST: Sapped sentiment

The Westpac Melbourne Institute Index of Consumer Sentiment rose by 0.6 per cent in January from 100.0 in December to 100.6 in January.
This is the third consecutive month when the index has been at or above the 100 level. That compares with 14 of the previous 16 months when the index had registered below 100.

However, having said that, it remains disappointing that despite a total of 175 basis points of rate cuts from the Reserve Bank since October 2011 the index is only 3.5 per cent above its level at that time.

Indeed, following the first rate cut in November 2011, the index surged by 6.4 per cent to 103.4 in November 2011. Consequently the index remains 2.7 per cent below the level in November 2011 despite 150 basis points of rate cuts from the Reserve Bank.

Components of the index provide some guidance as to why confidence has not responded to the lower rates. Respondents have become more guarded around their own finances. Assessments of "Family finances compared to a year ago” have fallen by 8.6 per cent; while the outlook for "family finances over the next 12 months” fell by 1.2 per cent. The overall economic outlook improved. "Economic conditions over the next 12 months” increased by 2.7 per cent and "Economic Conditions over the next five years” increased by 3.3 per cent. Possibly reflecting the rising Australian dollar, respondents assessed a 4.7 per cent increase in "good time to buy a major household item”.

Signals around the key sector of housing, which would normally be expected to respond most immediately to such a series of rate cuts, are mixed.

Over the last 12 months sentiment towards the sub index "whether now is a good time to purchase a house” has increased 11 per cent (quarterly average). For the last four months that index has been near the highs of 2009 when house prices lifted by around 14 per cent nationally and housing activity was strong.

On the other hand, a special question which was included in the current survey around the outlook for house prices shows 45.6 per cent of respondents expected house prices to rise over the next 12 months while the same question a year ago showed a slightly higher 46.9 per cent of respondents expecting prices to increase despite the cash rate having fallen by a further 125 basis points.

The movement of this Index of House Price Expectations since the last survey in October is even more curious. Whereas the net balance of the index jumped a healthy 9.1 points between July and October to 34.4 it has fallen back 7.7 points in January. This result points to a mismatch between purchase sentiment and the price outlook, which certainly supports evidence from housing finance data that the upturn will take longer and is less assured.

In that regard a closer look at the housing finance data confirms a much more subdued overall situation than we saw in 2009.

In 2009 we saw a surge in housing activity driven principally by first home buyers. In the year to September 2009 the number of approvals to FHBs surged by 76 per cent compared to a 27 per cent increase for upgraders and a 16 per cent increase (value) for investors.

In contrast, over the last six months, in the face of aggressive rate cuts from the Reserve Bank the number of new loans to upgraders has increased by 11 per cent while the value of new loans to investors is up by 13 per cent but the number of new loans to FHBs is down by 11 per cent.

In short the response of upgraders and investors to the low rates is similar to the response in 2009. However the response of FHBs has been sharply different. The importance of FHBs is emphasised by the overall growth in the number of new loans to owner occupiers which has increased by 5 per cent over the six months to November 2012 compared to an increase of 42 per cent over the year to September 2009.

The weakness of the FHB response is partly explained by the reduction in official subsidies to FHBs. In October 2008 the Commonwealth government doubled the First Home Owners Grant from $7000 to $14,000 for existing properties and increased the grant for new properties to $21,000. Today, two states (NSW and Queensland) offer a $14,000 grant for new properties only and no grant for existing properties. Victoria and Western Australia offer a grant of $7000 for existing or new, while South Australia offers $14,000 for new and $5000 for existing.

Other factors such as affordability; confidence around job security; more stringent lending guidelines from banks; and the "pull forward" effect we saw in 2009 will explain part of the reluctance of FHBs to support the market. However, the most important reason is likely to be the less generous subsidies. This provides probably the clearest example of how fiscal policy can support monetary policy in boosting demand. With the federal government no longer targeting the elusive surplus in 2012-13 there should be more scope for fiscal policy to support monetary policy in boosting private sector demand.

We do not argue that monetary policy has had negligible impact. The response from investors and upgraders has been encouraging. However, without the support of fiscal policy, the impact of low rates on housing, given other uncertainties around employment and household finances, is likely to be limited.

The Reserve Bank board next meets on February 5. Westpac has not changed its rate view since May last year when we nominated 2.75 per cent as the low point for the official cash rate. We continue to expect that there is a clear case for at least one more rate cut in this cycle and our target has been the February-March "window”.

Markets and commentators have generally expected that the boost to Australia's terms of trade following the jump in iron ore prices and the more buoyant outlook for the world economy might preclude further action from the Reserve Bank. Certainly previous episodes of sharp movements in commodity prices have been an important factor in the bank's deliberations (recall the decision to cut rates in October following the collapse in iron ore prices in August-September).

The case for a further rate cut as early as the February meeting is still reasonable. The employment report for December supports lower rates. The inflation report next week will also be important in that regard. Westpac expects that the core print will be 0.8 per cent following 0.7 per cent in the September quarter. The bank's assessment of that print will be affected by its view on how significant has been the carbon price effect on the core print. A 0.8 per cent print for the December quarter might caution against an immediate cut.

Furthermore, a prudent Reserve Bank which has seen a resurgence in the terms of trade, is likely to defer in February to await evidence around the impact of the rate cuts. Accordingly we have opted for the next cut to be more likely in the March end of our forecast "window”.

Bill Evans is Westpac's chief economist.