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05-05-2014

How does the OCR actually affect interest rates?

The Official Cash Rate (OCR) was raised by .25 percentage points recently, the first change since early 2009. Floating mortgage interest rates for most banks moved up by the same amount almost immediately. But what exactly is the OCR and how does it affect the mortgage interest rates we pay?

The OCR was introduced in March 1999 and is reviewed eight times a year by the Reserve Bank. The OCR is actually the interest rate for overnight transactions between banks. Among other things, the Reserve Bank acts as the central bank for most registered banks in New Zealand, who hold settlement accounts at the Reserve Bank.

To explain, if you write out a cheque or make an EFT-POS payment, the money is taken from your bank and put into the bank of the recipient. This causes the money within your bank and every other bank to go up and down each day according to what their customers are spending or depositing.  Depending on daily transactions, individual banks can end the day in credit or debit.

Much like an overdraft account, the Reserve Bank covers the ups and downs by either paying or charging interest to banks depending on whether they are in credit or debit. Banks can borrow money from the Reserve Bank at a rate 0.25 percent higher than the OCR, or lend money to it at a rate 0.25 percent lower than the OCR.

Short term interest rates are therefore influenced by the OCR because banks are unlikely to lend money to people for rates less than they could receive from the Reserve Bank, or to borrow at rates higher than they would pay the Reserve Bank.

By affecting overnight rates, the Reserve Bank has a strong influence on short-term interest rates such as the 90 day bill rate and floating mortgage rates.

However the impact isn't direct and may not be immediate. While overnight interest rates will respond quickly, longer-term interest rates may not. Some overseas investors will respond quickly to changing interest rates, but most consumers and businesses won't.

As the OCR affects short term interest rates, if a majority of mortgages are on long term fixed rates, then the OCR will have little effect on mortgage rates.

Why does the Reserve Bank change interest rates?

The Reserve Bank is responsible for implementing monetary policy in New Zealand. It operates under the Reserve Bank of NZ Act 1989 which states that the Bank must maintain price stability.

The Bank also operates under the Policy Targets Agreement (PTA) that it signs with Government.

The current PTA, signed in September 2012, defines price stability as annual increases in the Consumers’ Price Index (CPI) of between 1 and 3 per cent on average over the medium term, with a focus on keeping future average inflation near the 2 percent target midpoint.

The CPI is a list of 690 goods and services, whose prices are monitored by Statistics NZ to see if they are going up or down.

The Reserve Bank monitors the NZ economy and uses this huge bank of data to make predictions on where it sees the CPI and hence inflation is tracking.

If the Reserve Bank believes that inflation is going to go beyond the range it has been instructed to keep within, it will use the OCR in an attempt to keep inflation within the range.

As interest rates rise, people spend less, either because there is an increased incentive to save rather than spend or people with mortgages and other loans have less to spend. When people save more or spend less, there is less pressure on prices to rise, and therefore inflation pressures tend to reduce.

In addition to  having an influence on interest rates, unfortunately the OCR has an effect on other economic factors. As interest rates increase, NZ becomes more attractive to overseas depositors, who buy NZ dollars to access the higher interest rates. This increased demand for the NZ dollar increases its value compared to other currencies which makes NZ products more expensive in overseas markets.

One reason  the Reserve Bank introduced restrictions on Loan to Value Ratios (LVR) was to influence inflation. The theory is that if people are required to have higher deposits when  buying property, this will encourage them to save more to get a higher deposit. This reduces spending as well as the risk of over borrowing, while not having an effect on the exchange rate.

As with anything the Reserve Bank does there will be winners and losersas a result of these restrictions. This then begs the question, have we got our inflation targets set correctly in the first place?

The NZPIF would like to thank Massey University, The Reserve Bank, the NZ Institute of Economic Research, and the Parliamentary Library for information used in this article.

 

Tags: ocr - interest rates

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