Wednesday 25 May 2016

In 1933, US President Franklin D. Roosevelt pointedly noted that "confidence... thrives on honesty, on honour, on the sacredness of obligations, on faithful protection and on unselfish performance. Without them it cannot live". And over 80 years later these words still resonate with political, policy and business leaders as they grapple with increasingly fickle cycles of consumer and business confidence.

To be fair, global policymakers are currently confronting a perplexing set of factors in the aftermath of the financial crisis and major central banks' deployment of unconventional monetary policy via unprecedented asset purchase programs and negative interest rates. Arguably, the crisis of 2008-09 and its legacy continue to cast some doubt on the effectiveness and accountability of policymaking institutions in the major developed economies.

Confidence levels in the major developed economies have also been influenced by concerns about the socioeconomic consequences of the unrelenting pressure for ‘structural change’ in an increasingly competitive global economic system. At the household/consumer level, a key concern has been persistently high levels of unemployment faced in some regions and subdued income growth in developed economies, while for businesses, sluggish demand and highly competitive operating conditions continue to influence perceptions of resilience and confidence.

Consequently, as the global economy moves into the second half of 2016 it is important to understand the causes and consequences of shifts in consumer and business confidence and the possible implications for the business cycle and macroeconomic policy settings.

Confidence may be a case of shifting sands

With policymakers in the major economies working hard to restore and maintain confidence levels and shifts in sentiment indicators playing a key role in risk assessments of investors, it is worthwhile to consider the various influences on this qualitative economic measure.

Our analysis of the various indicators of consumer and business confidence that are regularly published highlight several common factors that have the potential to cause marked shifts in sentiment; including:

  1. Changes in interest rates and/or exchange rates, particularly if they are rapid, large and unexpected
  2. Swings in the business cycle and associated movements in employment/unemployment levels and business investment intentions
  3. Shifts in the relative prices of nondiscretionary goods and services, notably petrol, healthcare, education and utilities prices
  4. Large external economic and/or financial shocks, such as the financial crisis of 2008/09 and the Eurozone sovereign debt crisis of 2010/11
  5. Announced policy shifts in the stance of government fiscal policy, including large structural spending cuts or increases/decreases in taxation rates.

Interestingly, it is widely accepted by economists that the financial economy operating via interest rates and exchange rates acts as a buffer for the real economy in terms of external shocks, but this effect can often be magnified due to the out-sized impact on consumer and business confidence. For example, Australia was not directly affected by either the financial crisis or the subsequent Eurozone debt crisis, but on both occasions a considerable upsurge in general anxiety and slumping confidence were recorded.

Australian households and businesses reported concerns about the economy's vulnerability in the face of unprecedented upheaval in global financial markets. Not surprisingly, in some quarters concerns continue to be expressed that small open economies such as Australia and New Zealand often experience disproportionate reactions to economic and financial disturbances that emanate from much larger and more complex economies, including the US, the Eurozone, Japan, and China.

To be sure, we are not suggesting that economic policymakers should maintain inappropriate macro policy settings in order to buoy consumer and business confidence. Rather, the announcement and implementation of shifts in key macro policy needs to be sensitive to the psychological impact on households and firms in the real economy. It is the need to manage psychology that has led the major central banks to bolster their policy 'forward guidance' activities, as they fine-tune strategies to eventually end a period of extraordinary monetary policy accommodation.

It's not all in the mind as sentiment shapes activity

Although it is often said that 'confidence can turn on a dime', this should not be taken as diminishing the role of sentiment in shaping economic activity and in turn the path of business cycles. The power of confidence was patently demonstrated in late 2008 with the collapse of Lehman Brothers and the subsequent slump in global consumer and business sentiment. This was accompanied by an unprecedented collapse in global trade volumes, industrial production, investment and importantly risk-taking.

It is estimated that in the major developed economies, including Australia and New Zealand, consumer spending contributes up to two thirds of aggregate demand, based on income levels or changes, buying and spending trends, and underlying economic conditions. If we consider credit and liquidity to be the life-blood of the economic system, then it is reasonable to regard confidence as the oxygen that sustains the system.

So heightened economic anxiety and languishing confidence will have manifest impacts on the health and wellbeing of the economy, often determining whether or not it can reach and sustain its long term potential rates of growth. Recent experience indicates that there are several important consequences of low and declining levels of confidence, including:

  • unusually high household and business savings rates, including the hoarding of capital by financial and nonfinancial firms
  • subdued nominal income growth and tepid private sector credit growth
  • widespread household deleveraging
  • declining business investment spending and weak employment growth
  • dominance of short-term thinking and absence of longer-term strategic activity
  • risk of a decline in the economy’s structural growth rate and associated deterioration in productivity growth.

Therefore, economies facing 'crises of confidence' may find if this prevails it will undermine productive capacity and prove to be 'growth limiting'. In this event, it could lead to deterioration in living standards as the base of economic activity gradually contracts and the willingness and capacity to engage in risk-taking is curtailed.

Looking forward, the continuing desynchronised global business cycle and the likelihood that macroeconomic policy shifts will also vary over the next 12 months suggest that global consumer and business confidence will remain fickle. For policymakers this suggests that communication and announcement effects will continue to be crucial in managing confidence effects in economies. In contrast, investors and firms need to remain vigilant for unexpected shifts in confidence and/or the development of unsettling negative feedback loops.

For small open economies, like Australia and New Zealand, the careful management and guidance of confidence and sentiment now represents a crucial component of overall macroeconomic policy, but we suspect that finding the balance between maintaining appropriate policy settings and healthy levels of confidence remains a work in progress.

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