The Official Cash Rate (OCR) Explained

What is the Official Cash Rate?

The Official Cash Rate (OCR) is an interest rate set by the Reserve Bank of New Zealand. To be specific, it is the interest rate for overnight transactions between banks. Importantly, this interest rate defines the wholesale price of borrowed money. This directly affects the commercial banks, determining the rates they offer their customers. So it affects the rates banks charge for borrowing (mortgages, loans, credit cards), and what they will pay customers for saving (term deposits, savings accounts).

The OCR is reviewed seven times each year. A Monetary Policy Statement is also issued at four of those reviews.

What does the Official Cash Rate do?

As well as helping the banking system work, the OCR is a tool the Reserve Bank uses to influence the level of economic activity and inflation. It does this by influencing the cost of borrowing money in New Zealand.

How the Official Cash Rate works

The Reserve Bank acts as the central bank for most registered banks in New Zealand. These banks hold settlement accounts at the Reserve Bank. Settlement accounts are used to settle the obligations between the banks at the end of the day.

Say you make a bank transfer or use your EFT-POS card. The money is taken from your bank account and put into the bank account of the recipient. This causes the money within your bank’s settlement account to go down and the money in the vendor’s bank’s settlement account to go up. There are hundreds of thousands of these transactions each day. Depending on the total 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 they can lend money to it at a rate 0.25 percent lower than the OCR.

The key to the system is the fact that the Reserve Bank doesn’t limit the amount of cash it will borrow or lend at rates related to the OCR. This means the banks won’t run out of money.

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How does the Official Cash Rate actually affect interest rates?

Short term interest rates are influenced by the OCR. This is because banks are unlikely to lend money to people for rates less than they could receive from the Reserve Bank. Nor would they borrow at rates higher than they would pay the Reserve Bank. By affecting overnight rates, the Reserve Bank has an especially strong influence on short-term interest rates such as the 90 day bill rate and floating mortgage rates.

However the full impact isn't direct or immediate. While overnight interest rates will respond quickly, longer-term interest rates may not. 

Although the OCR influences New Zealand's market interest rates, it is not the only factor doing so. Market interest rates – particularly for longer terms – are also affected by the interest rates prevailing offshore. New Zealand financial institutions are often net borrowers in overseas financial markets. Movements in overseas rates can lead to changes in interest rates even if the OCR has not changed. (source: taken from RBNZ website).

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 then makes NZ products more expensive in overseas markets.

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Why does the Reserve Bank change interest rates?

The Reserve Bank monitors the NZ economy. They then use that data to make predictions on where it sees the CPI and hence inflation going. 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. Therefore inflation pressures tend to reduce.

The OCR isn't the only tool the Reserve Bank has to influence inflation. One reason the Reserve Bank introduced restrictions on Loan to Value Ratios (LVRs) 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.

What mandate is the Reserve Bank working under?

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 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. Its prices are monitored by Statistics NZ to see if they are going up or down.

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