Improvement in Irish consumer sentiment over the past two months will not necessarily lead to a dramatic rebound in household spending

An improvement in Irish consumer sentiment in each of the past two months suggests that the low point in the recent downturn lies some distance behind us. These data also suggest that, barring a further shock to this economy, spending by Irish households should be on an improving trend in the months ahead. However, there is little evidence as yet to suggest the upswing will be anything more than modest.

An array of factors are likely to have contributed to an improvement in consumer sentiment in April and May after very weak readings earlier in the year. First of all, it became clear that widespread fears of an economic meltdown were misplaced. In particular, a relatively contained rise in unemployment should have underpinned confidence.

Overlaid upon this key support was a substantial boost to household spending power from a variety of sources. These ranged from the receipt of tax cuts and increased child benefits to further payments under the terms of the Programme for Prosperity and Fairness. It might also be speculated that a strong rebound in the Irish property market and the windfall returns available from the special savings incentive scheme would also have boosted sentiment among consumers.

It would be wrong to expect that this rise in confidence in the past couple of months will translate mechanically into identical gains in household spending. Sentiment indices cannot be used to predict economic growth in this way. Nonetheless, they present important "big picture" evidence on the forces driving consumer behaviour. These range from the subjective judgment of households as to the broad economic situation to their assessment of their own financial positions. These perspectives may be particularly relevant to any analysis of current Irish economic conditions for several reasons.

One reason is that there has been renewed concern of late about how several Irish economic indicators, such as output and trade data, should be interpreted. The scale of activities in a small number of multinational companies operating in the Republic is so large that they may produce readings in these indicators that might not be representative of trends in the broader economy. In these circumstances, it is important that policymakers, analysts and businesses examine the broadest possible array of economic evidence.

Another reason why the trend in consumer sentiment may be increasingly important is that there has been a dramatic change in the structure of this economy in the past decade. The rapid rise in incomes during this period means that Irish households have far greater financial leeway than in the past. As a result, the discretionary spending behaviour of Irish consumers has become a key driver of the pace and make-up of activity in this economy.

It should also be noted that Irish consumer sentiment began to weaken in the second half of 2000, well before most economic forecasts incorporated the expectation of a significant slowdown in activity. This drop in consumer sentiment was broadly consistent with a softening in the pace of growth in household spending over the past year or two, although, as noted above, the correlation wasn't perfect.

As a result, I would not see the recent improvement in sentiment as heralding a dramatic rebound in consumer spending. Instead, if sustained, it points to a more stable spending climate in this economy in the months ahead. For many Irish businesses, that represents a significant change from the environment they faced in the past five years.

Of course, it should be remembered that changes in consumer sentiment are not solely linked to movements in spending or income. In a sense, sentiment is a barometer of economic well-being rather than a measure of how much is produced in the Irish economy. This aspect adds to the significance of sentiment as a broad indicator of economic conditions.

It may be that the weaker trend in consumer sentiment seen for much of the past two years reflected concerns about broader economic issues such as traffic congestion or the persistently high inflation rate as well as the emerging slowdown in activity. In the latter stages of 2001, a weakening property market may also have played a role. One could also speculate that the weakening trend in sentiment until the last month or so might have been expected to produce the late surge in applications for the special savings incentive scheme. The weakening economic climate of the past year or more would have hit sentiment and argued for a rise in precautionary or "rainy day" savings.

These broader dimensions are an important feature of sentiment indices. Although traditional economic models tend to assume constant relationships between variables, what households regard as the key issue facing them is likely to change, sometimes quite suddenly. These changes can often have far-reaching economic consequences. As a result, one of the most valuable attributes of the Irish consumer sentiment index is that it forces us to ask questions as well as providing answers.