The OCR: a tool NZ's most powerful banker uses to get you spending or saving

Thursday, 9 August 2018

What does the official cash rate mean?

No one in the real world borrows money at the official cash rate (OCR), so why is such a fuss made when the Reserve Bank says it's going up, down or even staying the same?

While the relationship has become somewhat diminished in recent years as interest rates fall to ultra-low levels, the OCR is a tool used by the Reserve Bank in a bid to control inflation by encouraging you to spend or save, as economic conditions demand.

If the Reserve Bank is concerned that the economy is overheating, it will seek to push up interest rates to try to discourage spending to prevent a worse problem down the road.

But if it fears that the economy is cooling it will try to lower interest rates to try to get households and businesses spending, to generate activity and confidence.

Technically speaking, the OCR is the interest rate the Reserve Bank pays on settlement accounts, which the retail banks use to settle debts owed to each other, to reconcile the tens of thousands of payments made by customers each day. It also allows banks to borrow overnight at the OCR.

Crucially the central bank 'sets no limit on the amount of cash it will borrow or lend at rates related to the OCR' to registered banks. This allows the OCR to have a direct influence on short term borrowing rates.

The OCR is reviewed seven times a year, as a means of influencing inflation, which it is tasked with keeping in a 1-3 per cent range.

Adrian Orr, who rose to prominence as the chief executive of the NZ Super Fund, is now governor or the Reserve Bank, which reviews the ideal level for the official cash rate, seven times a year.

All else being equal, if the OCR is raised, floating rate mortgages will increase, as will on call cash deposit rates, while the opposite will happen if the OCR is cut. Fixed rate mortgages are also influenced, but on what banks think will happen to the OCR (and other borrowing costs) over time.

If inflation is headed higher, the Reserve Bank may either increase the OCR or signal it is going to increase interest rates in the future. If inflation is too low it will cut the OCR, and signal that it is prepared to cut further if needed to stimulate spending.

When the global financial crisis hit, the OCR was slashed from 8.25 per cent in June 2008 to 2.5 per cent in April 2009. It now sits at 1.75 per cent, an all time low, as central banks around the world struggle to generate inflation.

In the most simple terms, if interest rates are high, individuals and businesses are more likely to save, meaning they spend less. Less money being spent tends to mean lower inflation, and it also tends to push the New Zealand dollar higher, as international investors park their money here to earn higher interest rates.

On the flip side, when interest rates are low, it tends to stimulate spending and investment, both by households and businesses. For budding home owners, lower interest rates mean their income can service a larger mortgage, while for businesses, investments do not need to generate the same increase in profits to cover the cost of borrowing than if interest rates were higher.

For years, when the OCR was moved, there was an almost immediate impact on floating mortgage rate in direct proportion to the movement.

But the relationship between the OCR and mortgage rates has become a little looser over time.

When the OCR was cut in 2016, however, New Zealand's banks passed on less than the full amount of the cut, blaming the retention on increased international funding costs, with most of the money banks use to lend to customers coming from offshore.