Business decision makers and economic forecasters have over reacted to a slump in consumer sentiment in 2008. This letter was published in the Australian Financial Review on 19 June 2008.
The article by David Bassanese on consumer sentiment indices (“History says low confidence can hurt”, AFR 17 June 2008, page 25) is very interesting but it is as shame that he did not mention research by the Reserve Bank of Australia (“What do Sentiment Surveys Measure?”, Research Discussion Paper 2001-09 by Roberts and Simon). Their conclusion, in a nutshell, is that the index of consumer sentiment (ICS) does not tell us anything that we did not already know and that they offer little information about the future path of the economy. In other words, there is little or no information beyond what is known from factors such as interest rates and income growth.
Similar findings are not rare (eg “Composite Forecasts, Non-stationarity and the Role of Survey Information by Holly and Tebbutt, Journal of Forecasting, Vol. 12, 1993). Our own research has concluded that the ICS is like a rear vision mirror, reflecting past values of interest rates, unemployment, and especially the Australian dollar exchange rate.
Sentiment plunges during a recession because in many cases it has been caused by high interest rates and unemployment tends to be rising.
But ICS can also be very misleading. For example when retail sales growth was stalling in late 2004 (due to sharply higher petrol prices and a stall in house price inflation), ICS was rising due to falling unemployment and the strong dollar. ICS slumped to under 100 in late 2006 but retail sales were booming.
The slump in ICS this year is an over-reaction to a lot of bad economic news including the fallout of the sub-prime crisis in America, the stockmarket correction, rising interest rates, and higher petrol prices. While slower economic growth would be expected to follow these shocks it seems that most economic forecasters have over-reacted too. Witness the AFR page one story commenting on the March National Accounts “The economy grew faster than expected in the first quarter … Gross domestic product expanded by a surprisingly robust 0.6 per cent … households and businesses proved unexpectedly resilient …” (“Robust economy fuels rate fears”, AFR 5 June 2008).
Unfortunately, ICS is a good predictor of business confidence as measured by NAB (interest rates and petrol prices also drive business confidence). This means that business decision making can be sub-optimal. When ICS moves up or down sharply, some businesses over-react in their decisions on investment, production, and marketing.
Business decision makers (and economic forecasters) would be well advised to ignore ICS and focus on economic fundamentals.