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After a gradual recovery from the substantial fall in real incomes and the rapid increases in interest rates during the three years following the end of the COVID-19 pandemic, the Australian economy now appears to be in the early stages of another, potentially significant downturn.<\/p>\n
Although there is as yet little hard statistical evidence to confirm that, this week\u2019s news of plummeting consumer and business confidence provides an ominous signal.<\/p>\n
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Illustration by Simon Letch<\/p>\n
The Westpac-Melbourne Institute index of consumer sentiment dropped 12.5 <\/a>per cent in April, the largest single-month decline since April 2020, immediately after the onset of the pandemic, to its lowest level since September 2023, just after the 12th of what would ultimately be 13 increases in the RBA\u2019s official cash rate, and only 4.5 points above that April 2020 level, which was in turn the lowest since the recession of the early 1990s.<\/p>\n Almost certainly, the fall in consumer confidence is in response to the sharp increase in petrol and diesel prices and apprehension at the possibility of fuel shortages.<\/p>\n Perhaps surprisingly, consumer confidence fell by more among people who own their homes outright and among renters than among people with mortgages \u2013 suggesting, possibly, that people are more worried about falling house prices than about higher interest rates. Also surprisingly, there was a much larger drop in confidence among people earning over $100,000 a year than among lower-income earners (perhaps they\u2019re worried about the impact on the share market). Less surprisingly, consumer confidence fell much more among younger people than older ones.<\/p>\n Related Article National Australia Bank\u2019s measure of business confidence also plummeted in March to its lowest level since April 2020.<\/p>\n While measures of consumer and business confidence are not ordinarily reliable proxies for harder indicators such as retail sales, employment or business investment, big movements in consumer and business confidence such as those reported this week usually do presage significant turning points in the economy.<\/p>\n And that\u2019s consistent with economists\u2019 expectations that the spike in fuel prices since the outbreak of Gulf War III \u2013 and the fact fuel prices have stayed high despite the apparent suspension of military hostilities in the Gulf \u2013 will likely result in a significant downturn in economic activity, as well as an increase in inflation.<\/p>\n From the perspective of the Reserve Bank and the Treasury, and at the highest levels of government, the appropriate response to these developments is far less clear-cut than it was at the onset of the global financial crisis 18 years ago, the pandemic six years ago, or in the aftermath of Russia\u2019s invasion of Ukraine just over four years ago. Though the increases in costs for fuel, airfares, and a growing range of other goods and services will add to both headline and underlying inflation, prompting speculation about the inevitability of a third successive increase in interest rates at next month\u2019s Reserve Bank meeting, that is not necessarily a done deal.<\/p>\n That\u2019s because unlike the unexpected rebound in inflation in the second half of last year which prompted the two recent rate rises \u2013 the current surge in inflation isn\u2019t the result of \u201cexcess demand\u201d, for which higher interest rates is the normal remedy. Additionally, the impact of the current surge in fuel prices on household finances is, in aggregate, very similar to that of an increase in interest rates \u2013 albeit distributed differently across individual households. That is, higher fuel prices mean that households who have little choice about how much fuel they use have less to spend on other goods and services, which reduces aggregate demand for those other goods and services in much the same way as higher interest rates mean that those with mortgages have to devote more of their incomes to paying interest and thus have less to spend on other goods and services.<\/p>\n So raising interest rates in response to the first-round impact of higher fuel prices on inflation would be doubling up \u2013 and increasing the risk of a recession.<\/p>\n The Reserve Bank should only increase interest rates if it judges there is a serious risk that people and businesses have begun to expect that inflation will remain permanently higher \u2013 because history tells them that if inflationary expectations do become entrenched at higher levels, people and businesses will start to behave in ways that make it more likely that inflation will become permanently higher, as it did after the oil shocks of the 1970s.<\/p>\n But it is too soon to make that judgment as yet.<\/p>\n For its part, the federal government \u2013 and probably state governments \u2013 will be tempted to offer additional cost-of-living relief to households, to help alleviate the impact of higher fuel and other prices on household budgets. They must resist. If governments throw cash at households \u2013 especially in an untargeted way, as they did with their electricity bill rebates between 2023 and 2025 \u2013 that will offset the effect higher fuel prices are having on household demand for other goods and services. This would give the RBA less reason to think that demand for those other goods and services will ease without further interest rate rises.<\/p>\n So, if the federal and state governments want to help reduce the risk of further rate hikes \u2013 and hence the risk of recession \u2013 they should do as little as politically possible by way of providing cost-of-living relief in their upcoming budgets.<\/p>\n Related Article And they should also resist the temptation to support additional wage increases \u2013 which in current circumstances would also likely result in further price increases, in turn increasing the risk of further increases in interest rates. That\u2019s a tough message for workers \u2013 but the point is that the benefits (to households) of additional wage increases are now likely to be taken away from those households with big mortgages in the form of higher interest rates.<\/p>\n Instead, the focus of upcoming budgets should be \u2013 as Treasurer Jim Chalmers and others have indicated \u2013 strengthening Australia\u2019s resilience to shocks like the present one, reducing intergenerational inequity through tax reform and other methods, and boosting productivity.<\/p>\n Saul Eslake is former chief economist of ANZ Bank and of Bank of America Merrill Lynch in Australia, and is now principal of Corinna Economic Advisory based in Hobart.<\/p>\n The Opinion newsletter is a weekly wrap of views that will challenge, champion and inform your own. 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