Every six weeks the official cash rate is revealed. It goes up 25 basis points, oooh. Or it drops 50, aaah. It stays on hold, oooh. Financial journalists pontificate, banks make profits (regardless) and everyone else stays pretty much baffled about what ‘basis points’ are and how they can win some.
Every three months there is extra confusion when the Monetary Policy Statement (MPS) is released alongside the Official Cash Rate (OCR). And then you can wade knee deep in economics jargon while learning that economies can soften, and housing can get hot.
So what does it all mean? Who creates monetary policy? Who decides the official cash rate, and why?
Last week when the OCR and the MPS came out I sat down with RNZ’s Gyles Beckford and Kim Savage. You can hear their genius explanations (with help from RBNZ Governor Adrian Orr) in the audio above.
None of this is difficult really but it does involve numbers, so wear gloves while handling the sharp ones.
Fiscal versus Monetary
There are two tall buildings that face off against each other across the road from Parliament in Wellington. They’re easy to confuse because they both do lots of maths. At No 1 The Terrace is The Treasury - New Zealand’s Fiscal Authority. That’s all the tricky calculator work behind government spending (the budget, financial strategy etc). There are lots of clever economists in there, and more besides; but they’re not involved in this at all. They're the star of the show on budget day.
Across the road at No 2, is their sister institution and occasional combatant, The Reserve Bank of New Zealand (RBNZ). More clever economists. The RBNZ is the Monetary Authority. It’s a Central Bank (every country has one of these), and does a few things, including making sure banks don’t break the rules or go bust, storing gold, and printing money. But they also run New Zealand’s monetary policy. And critically they do this independently. The Government gives them goals but they make all the calls free from interference from Government and Parliament (but they do turn up regularly to explain their thinking to Parliament).
The RBNZ watches the economy and tweaks the money supply to try to keep inflation (the speed that things get more expensive) between 1percent and 3 percent (the Goldilocks zone). They also have an eye on keeping employment as high as possible without it screwing with inflation.
Did you know full employment was a bad thing?
SIDENOTE: Employment screws with inflation either when: a) so many people are unemployed that they will accept pay cuts. In this scenario the economy slows down as less money is earned and spent (deflation); or the opposite b) there are so few people available to hire that they can demand much higher wages, causing inflation. The ideal economy requires some unemployment, (in economic speak, maximum sustainable employment). Apparently New Zealand is pretty much at maximum sustainable employment now.
Twiddling the Dials on the Money Machine
There are a few ways that the Reserve Bank can tweak the money supply to influence the economy (monetary policy), including adding more money in (called quantitative easing), but the usual way is via the Official Cash Rate (OCR).
“It’s easy” says Gyles Beckford, with the sly smile of someone who knows it’s a lot more complicated than they claim “the Reserve Bank sets the price of money”.
How the OCR works practically
Basically, the Reserve Bank is the conduit for money flow between other banks. Banks keep a store of cash at the Reserve Bank and settle their debts with each other every night via the RBNZ. When banks have a positive balance at the RBNZ they get paid interest (based on the OCR), and when they are in deficit they get charged interest at a rate based on the OCR.
Banks, in turn, charge their customers to borrow money at a rate also based on (but a profit margin above) the OCR. When the OCR goes up they charge more for borrowing money. When it goes down they charge less. They always keep a bit for themselves (strange that).
When Money is Cheap
The small differences in what it “costs” to borrow money affect how businesses and people act. When cash is cheap (a low OCR) we’re more likely to borrow (and buy houses, or invest in new business equipment etc). We’re also more likely to spend rather than save any excess (because returns on savings accounts are lower when money is cheap).
All that spending speeds up the economy (more money flowing around) and increases inflation.
So when the RBNZ thinks inflation might dip soon it is likely to make money cheaper by lowering the OCR. They do it early because economic effects have a lag.
When Money is Expensive
When money is expensive (a high OCR) we’re likely to save money, to try and reduce our mortgages and are likely to borrow to invest. That slows the economy down (less money flowing) and usually leads to lower inflation.
That’s the idea anyway. If the Reserve Bank wants to add a bit of spice to the economy they make money cheaper for the banks. If they want to cool it down, they make it more expensive.
Foreign Exchange Rates and the OCR
There are of course always unintended consequences (because economies are not simple systems). For example when interest rates are low in New Zealand compared to other countries, investing in the NZ currency is less attractive. This reduces demand and the value of the NZ dollar falls a little. If interest rates here are higher than in other countries there is higher demand to invest via our dollar and it is worth more. This is only one of the influences on the currency though, so nothing may happen at all. Economics is complicated.
Oh yeah, basis points
By the way, if you were wondering what basis points were they are hundreths of a percent. So 25 basis points is 0.25 percent. See it really is easy. This week when the OCR dropped 25 basis points it went from 1.75 percent to 1.5 percent.