The Official Cash Rate (OCR) explained

What is the OCR?

The OCR is an interest rate set by the Reserve Bank of New Zealand which 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 Reserve Bank reviews the OCR eight times a year.   Monetary Policy Statements are issued with the OCR on four of those occasions. Unscheduled adjustments to the OCR may occur at other times in response to unexpected or sudden developments, but to date this has occurred only once, following the 11 September 2001 attacks on the World Trade Centre in New York.

What the OCR does

The OCR influences the price of borrowing money in New Zealand and provides the Reserve Bank with a means of influencing the level of economic activity and inflation. An OCR is a fairly conventional tool by international standards. In the past, the Reserve Bank used a variety of tools to influence inflation, including influencing the supply of money and signalling desired monetary conditions to the financial markets. Such mechanisms were more indirect, more difficult to understand, and less conventional.

How the OCR works

Most registered banks hold settlement accounts at the Reserve Bank, which are used to settle obligations with each other at the end of the day. For example, if you write out a cheque or make an EFTPOS payment, the money is paid by your bank to the bank of the recipient. Many hundreds of thousands of such transactions are made every day. The Bank pays interest on settlement account balances, and charges interest on overnight borrowing, at rates related to the OCR. These rates are reviewed from time to time, as is the OCR. The most crucial part of the system is the fact that the Reserve Bank sets no limit on the amount of cash it will borrow or lend at rates related to the OCR.

The graph shows that the path of 90–day bank bill rates closely follows the OCR.

As a result, market interest rates are generally held around the Reserve Bank’s OCR level. The practical result, over time, is that when market interest rates increase, people are inclined to spend less on goods and services. This is because their savings get a higher rate of interest and there is an incentive to save; and conversely, people with mortgages and other loans may experience higher interest payments.

When people save more or spend less, there is less pressure on prices to rise, and therefore inflation pressures tend to reduce. 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)

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How does the OCR actually affect interest rates?

The OCR was introduced in March 1999 and is reviewed seven 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.  Why does the Reserve Bank change interest rate?

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. (Source: New Zealand Property Investors' Federation website)

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Why does the Reserve Bank change interest rate?

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 losers as a result of these restrictions. This then begs the question, have we got our inflation targets set correctly in the first place?

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