The OCR: What you need to know

12:46 pm on 23 November 2022
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Explainer - The Reserve Bank is expected to raise the official cash rate (OCR) by its largest margin ever today, and economists say it could rise further still.

But what is the OCR? Why is it rising and what does that mean for homeowners? And how can a higher official cash rate help combat inflation?

RNZ is here to clear it all up.

What is the OCR?

The OCR is the benchmark interest rate in New Zealand. It is the wholesale rate at which banks can borrow money.

Changes to this wholesale interest rate flow through to the rest of the economy as banks use it to help set both the interest rates at which they lend money to consumers and businesses, and the interest rates they offer those with bank deposits.

For example, if the OCR is set at 3 percent, banks will charge their customers that 3 percent, plus an additional margin on top. This is why changes to the OCR are generally reflected in the market interest rates offered to consumers by lenders.

The OCR was introduced in March 1999 as a tool to help control inflation, which is an increase in the general price of goods and services, often measured in New Zealand by the consumers price index (CPI).

Who sets the OCR?

The OCR is set by the Reserve Bank of New Zealand's (RBNZ) Monetary Policy Committee and is reviewed seven times a year. Very occasionally it is also adjusted in response to unexpected or sudden developments; this has only happened twice so far: following the 11 September, 2001 attacks on the World Trade Center and in response to the Covid-19 pandemic.

It has been the RBNZ's primary monetary policy tool to maintain price stability and support maximum sustainable employment since its introduction.

The committee's remit is to keep New Zealand's inflation between 1 percent and 3 percent on average over the medium term.

Why is it rising and how does a higher OCR combat rising inflation?

The OCR, which had been steadily dropping since 2015, hit a record low of 0.25 percent in 2020 as the Reserve Bank reacted to uncertainties around the unfolding Covid-19 pandemic, however, it has been rising again since late 2021 as global supply disruptions and domestic labour shortages bite.

Essentially, there is currently too much money in the economy and too few goods, and the competition for those available goods means their cost is rising.

Chief Kiwibank economist Jarrod Kerr told Morning Report the consumption was being driven by the fact the country had seen a very strong economy over the past couple of years and New Zealand had "bounced out of Covid quite nicely" thanks to the various stimulus measures implemented.

But despite the annual inflation rate falling very slightly in the year to September from a 32-year-high of 7.3 percent in June (due to the global price of fuel dropping), consumer prices rose 2.2 percent over the quarter, which is why everyone has noticed their supermarket bills going through the roof.

So, how does the RBNZ try to get that inflation under control? It tweaks the OCR to try and suck some money out of the economy.

The Monetary Policy Committee noted in its October review of the cash rate that the level of domestic spending had remained resilient, employment levels were high and household balance sheets remained resilient despite the fall in house prices.

By increasing the OCR, the cost to consumers of borrowing money from their banks also increases, and as consumers find themselves spending more of their take-home pay on servicing their debts, they have less money to spend on other things.

As demand for those other items drops, the reduction in competition for them should see prices begin to ease.

Kerr said if people spent less money shopping, it would help bring inflation down.

"The whole point of lifting interest rates is to reduce consumption in the economy, reduce demand - try and get demand down to where supply can handle it - and that's exactly what the Reserve Bank's trying to engineer."

What does a higher OCR mean for homeowners and first home buyers?

For much of the past decade, New Zealand's economy has been awash with money. As the populations of many Western countries have aged, those with savings poured them into bank deposits, meaning banks had access to a lot of funds to lend out.

That, coupled with the OCR being at its record low of 0.25 percent in 2020, meant banks could offer borrowers historically-low interest rates.

Speaking to The Detail earlier this month, the New Zealand Herald's Thomas Coughlan said the statistics showed that those looking to buy a house in recent years took advantage of those low rates, with first-home buyers borrowing $17.88 billion in 2021, up from $10b four years prior.

So house prices were skyrocketing, but the cost to borrow money was low.

However, the OCR has since risen to 3.5 percent and it is tipped to be hiked above 4 percent today.

That could spell financial pain for those who took out mortgages during the pandemic.

While those who had fixed their mortgages for five years when the OCR was at 0.25 percent would now be "saving a lot of money", Coughlan said, those on floating rates or shorter-term fixed rates would be suffering as those rates had "drifted up" with the OCR.

And unlike in some other countries, New Zealanders tended not to fix their mortgages for long periods to give themselves additional security, Coughlan added.

"We do have an unhealthy reliance on quite short-term borrowing."

Kerr said a lot of households would be rolling off those historically-low interest rates in the coming months.

The interest expense on an $800,000 loan, for example, could rise from around $20,000 to around $50,000, he said.

"It's a lot of extra money."

CoreLogic said in June that the rising mortgage interest costs were expected to hit many homeowners, with 48 percent of mortgages needing to be refinanced over the year ending March 2023.

Adding to the potential pain for homeowners, there has been a recent fall in house prices.

QV House Price Index data last month showed that the national average home value had recorded its first annual drop in a decade.

Kerr said those with mortgages were going to be in for a rough ride.

"Inflation is public enemy number one at the moment and the Reserve Bank is doing what they can to tame inflation ... what they do is they lift interest rates to tame the inflation beast and we're seeing interest rates rise quite rapidly."

He said people should take note not only of today's OCR decision, but also of what the Reserve Bank might signal it would do in coming months.

"I think they're going to signal that there's more rate rises to come and that they'll want to take the cash rate to 5 percent, which is a significant jump."

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