Uncertainty dents Australian economy, likely to trigger a rate cut

The Australian economy is most susceptible to be affected by economic uncertainty that prevails in the lead-up to federal elections, according to the economic uncertainty index for Australia, developed by ANZ Research. The indicator captures most of the major disruptive events that have occurred over recent decades, both domestically and overseas, distilling the common trend from a number of domestic and foreign measures of uncertainty.

The index showed that uncertainty remains a drag on the Australian economy, but its effects tend to be short-lived. Consumer and investor confidence is dented by growing uncertainty that can trigger a policy easing by the Reserve Bank of Australia, which is likely to prevent a spillover to the rest of the economy, ANZ reported.

The ANZ uncertainty index is currently just above its long-run average, which reflects some uncertainty about the upcoming federal election and possibly concerns over the possible exit of the UK from the European Union.

"The index also suggests to us that shocks to uncertainty tend to be persistent. That is, when uncertainty spikes significantly, the index remains elevated for an average of 2-3 months before gradually declining towards its long-run average," ANZ reported in its index report.

The result suggested that uncertainty tends to pick up during federal elections. However, the measurement failed to find any significant correlation between poll results and the domestic component of uncertainty.

Using a vector auto-regression model, the impact of a shock of one standard deviation to the uncertainty index was stimulated, which showed that consumer confidence edges down by about 1½  points over the two months after the shock, with the effect fading over subsequent months. Business sentiment will fall sharply, down about 2 points over the two months following the shock, although the impact also fades over the following 3-4 months.

Further, firms’ willingness to hire is likely to edge down, with ANZ job ads down 0.6 percent one month after the shock, although after six months the effect is more than reversed. The cash rate will drop by a bit less than 25 basis points by about 3 months after the initial shock, which is about a month after the decline in business and consumer confidence. However, the cash rate tends to remain lower for at least 12 months.

Meanwhile, the decline in cash rate remains a significant response of monetary policy to the deterioration in confidence and hiring intentions. Importantly, the fact that business sentiment and consumer confidence slowly recover after the shock suggests that households and firms may only briefly delay their spending decisions, ANZ reported in its recent research note.