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Why are we so pessimistic?

The optimism in the business sector that is evident in the Dun & Bradstreet and NAB business surveys has failed to translate to stronger economic activity, lower unemployment or any clear sign that the economy is doing well.

It goes to show that the business sector is just one part of the economy – an important one to be sure, but just one cog in the system. There is no doubt that it is important for the business sector to do well. But in isolation, high levels of business optimism are not enough to get economic growth to an above trend pace, the unemployment rate down and living standards higher.

To understand why the economy remains problematic, why the budget is still in large deficit and why the RBA has set interest rates at record lows, despite buoyant levels of business confidence, one only has to look at consumers.
Consumer sentiment is languishing in the doldrums and is a factor holding back household consumption spending.

The Westpac – Melbourne Institute index of consumer sentiment continues to show more pessimists than optimists, a position that has been evident for nine months. This extended period of pessimism is rare. The last time consumers were pessimistic for such a duration was in 2008, as the global economy plunged into the deepest recession since the 1930s.

When consumers are pessimistic, they tend to curtail spending growth. There is caution about running down savings or adding to debt because weak sentiment is usually associated with a lack of job security, weak incomes growth and cost of living pressures.
These dynamics are at play in the economy tight now.

In terms of cost of living pressures, a further threat to consumer sentiment and spending will come in the form of higher energy prices. The 15 to 20 per cent lift in electricity prices, which took effect from 1 July, will show up in bills in the next few months. In addition to hitting the cash flow of consumers, it is likely to create further uncertainty in the minds of consumers. The news of these bills will be high profile and will sap confidence.

Next week, the Australian Bureau of Statistic releases the next round of wages data. These are likely to confirm annual wages growth stuck around 2 per cent, which is effectively the same as the increase in inflation. As a result, real wages are flat or even falling slightly, which means that for a given level of spending for consumers, wages growth is not allowing for a reduction in household debt or increase in savings, because all wage increases that are being delivered are gobbled up by inflation.

The bottom line for the economy is that it continues to muddle along. A recession is a million miles away, a strong pick up in growth and significant reductions in unemployment are similarly illusive.

The business sector optimism needs to spread to consumers and it appears the missing link is the on-going weakness in income and wages growth. To get wages growth higher, the economy needs to be stronger and the unemployment rate lower.

This means interest rates will remain very low for an extended period of time and, if inflation and wages growth remains low, there is still a better than even chance the RBA will move rates even lower as it aims to inject some momentum into the economy.