The Reserve Bank has raised the Official Cash Rate to 2.75 percent to to help contain rising inflation pressures.
Thursday's increase, the first in three years, will flow through to mortgage and bank deposit rates.
Radio New Zealand's economics correspondent looks at the Official Cash Rate, what it does and where it's headed.
- What is the Official Cash Rate?
The Official Cash Rate is the interest rate set by the Reserve Bank to meet its inflation target of 1 to 3 percent on average over the medium term, with a focus on keeping future average inflation near the 2 percent target mid-point.
The OCR was introduced in March 1999 and is reviewed eight times a year by the central bank. Monetary Policy Statements, when the Reserve Bank updates its forecasts, 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 9/11 attacks in 2001.
- What does the OCR do?
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 does the OCR work?
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 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.
- What are the prospects for future OCR rises?
On Thursday, benchmark interest rate was raised to 2.75 percent.
It had been at a record low 2.5 percent since March 2011, when the Reserve Bank cut the cost of borrowing from 3 percent in response to the devastating earthquake in Canterbury in February.
The Reserve Bank signalled the OCR will rise to 4.75 percent by 2015. But it could be more if the economy, led by the rebuilding of Canterbury and high global dairy prices, accelerates even further.
It's very unlikely, though, that the Reserve Bank will hike the OCR to more than 8 percent as it did before the global financial crisis in 2008 to try and cool a rampant housing market.
Most think it will peak at about 5 percent, depending on the strength of the economy.
- Will mortgage costs go up?
Borrowers will pay more. Floating mortgage rates are about 5.75 percent, and economists expect that could rise to about 8 percent in the next couple of years. More people are likely to move to term fixed mortgage rates, and protect themselves from future rate increases. Currently, about 73 percent of borrowers are on floating or fixed rates of less than one year.
- Won't it push a high dollar even higher?
It's not expected to, even though New Zealand will be the first developed nation to lift the cost of borrowing. That's because the OCR increases are already priced in. The only way the dollar might rise substantially is if the RBNZ hikes by a surprise half a percent, and indicates an aggressive series of hikes will be needed. But that's not expected to happen.
- What about savers?
Savers, who tend to be the elderly and those on fixed incomes, have missed out following the fallout of the global financial crisis, with central banks lowering interest rates and printing money to support economies.
In New Zealand, on call deposit rates stand at about 3.5 percent. That's starting to change, with some banks lifting longer term deposit rates. Some economists expect rates to increase 2 to 3 percent over the next few years.