How do we use the OCR to influence short-term interest rates?
At the Reserve Bank, one of our main missions is to keep prices stable and inflation steady. To do this we increase or reduce something called the official cash rate or OCR, to influence the interest rates banks offer their customers.
Whether with a bank interest rates are high or low affects how much people borrow save and spend, and the amount of borrowing saving and spending going on in New Zealand affects prices but how does the OCR exactly affect interest rates?
Banks are like shops you see, they get their product, which happens to be money, at a wholesale rate, then they add a margin. It's like buying bananas from a bulk supplier then marking them up a bit to make a return. The Reserve Bank and retail banks are some of these wholesale suppliers who can influence the rates banks offer their customers.
One way the Reserve Bank does this is through what we call the OCR corridor system. Think of the Reserve Bank as the banks Bank. When banks borrow from us, we charge them a wholesale rate which we set at half a percent over the OCR. This sets an upper limit on rates that banks charge each other as banks could always come back to the Reserve Bank for a better deal and when banks deposit money with us, we pay them interest at the OCR.
This sets a lower limit on wholesale rates that banks charge each other again as banks could always come back to the Reserve Bank for a better deal.
The spread between our deposit and lending rates encourages banks to borrow and lend to each other at rates in between the OCR corridor system. But our job doesn't stop there because wholesale rates can continue to move around due to the supply and demand for cash in the wider system.
So the second thing we do to balance this out is to steady the amount of cash in the wider system. This is called the settlement cash system.
Picture all the cash in New Zealand's financial system has a large pool of water. The pool has an optimum level where funding costs set at the OCR but big government transactions like tax and pension payments can cause the water level to change.
Too much cash in the system, like after pensions are paid, can reduce banks funding costs because there is more than enough money to go around. Too little cash like after taxes collected, can increase bank funding costs because there's less money to call on.
The Reserve Bank can fine-tune how much cash is under pull by injecting and withdrawing cash to keep wholesale rates as close as possible to the OCR. This helps to reduce big swings and the cost of short-term borrowing and lending for banks and their customers.
The Reserve Bank's OCR corridor and settlement cash system tools are some of the many influences that can affect short-term rates and the rates banks offer their customers.
As for long-term rates like a fixed mortgage from well that's less affected by the OCR and more by the economic environment, expectations to future interest rates and developments in global interest rate markets.
The Reserve Bank keeps an eye on interest rates to make sure they are in line with the bank's inflation targeting role which helps to keep prices stable.
The OCR and how it works
The Reserve Bank sets the Official Cash Rate once every six weeks, or seven times a year.
The OCR is a powerful signal that the Bank uses to dial up or down the cost of money – that is, interest rates – that people and businesses pay when borrowing for everything from houses, to cars, to credit card purchases, or that they receive on their savings.
These interest rates, all together, affect the rate of consumer price inflation and the level of activity in the economy.
The Reserve Bank’s aim is to keep prices stable. If the economy overheats, higher interest rates can discourage excessive borrowing and spending, and encourage saving, which helps to keep a lid on inflation.
If the economy slows too much, lower interest rates can encourage the borrowing and investment the economy needs to grow.
The Reserve Bank makes OCR announcements at exactly the same time each time. Financial markets react immediately. But the effects go well beyond that.
The OCR sets the overnight rate for banks. Say the OCR is 3 percent. The banks will charge their customers 3 percent plus a premium that’s set by the market.
The important thing to understand is that when the OCR changes, banks may change their lending and deposit rates too.
And this spreads out over time from the major financial institutions to the retail market for businesses and households.
Interest rates affect the decisions that we all make about saving, lending, and borrowing money. For a 20-year house mortgage, a buyer’s decision is affected by the interest rate today but also by rates they expect to see down the line.
Trimming interest rates in New Zealand reduces demand for the Kiwi dollar. A lower Kiwi dollar means we pay more for the goods we import. This raises the prices of the everyday goods we import like cars and electronics.
But our exports become cheaper for overseas buyers which encourages exporters to grow their businesses.
The OCR also affects what each of us does with our money, whether we decide to buy or borrow or save. If interest rates are low, people may renovate their homes. They may spend more, and be less inclined to save.
And if lots of us are spending more, businesses feel confident about producing more, and investing in new technology and machinery to meet the extra demand.
But as businesses work hard to produce more, there is more pressure on the limited resources in the economy. This pressure drives up prices, and the cost of everything – from people’s labour to the price of raw materials – goes up.
A few weeks before the next OCR, market chatter will grow about what the Reserve Bank will do. The OCR announcement goes out. Financial markets react and so the cycle begins again.
This video is narrated by our economist Marea Sing.
Audio:
Have you ever wondered why the cost of your morning coffee has gone up over the years?
Price increases like this across the economy are what we call inflation.
Our role here at Te Pūtea Matua is to ensure New Zealanders can plan for the future with the confidence that their money will hold its value, by keeping inflation low and stable.
Inflation happens when there's a general increase in prices across a wide range of goods and services in the economy.
It means our money loses its value and buying power over time. We usually see inflation increase when demand for goods and services outpaces supply. For example, if lots of people want to build a house but there are too few builders or materials, the cost of building goes up.
This is because businesses will charge higher prices for their goods or services as long as their customers are willing to pay more. When this happens more generally in the economy, we call this demand pull inflation. But prices can jump around for other reasons too. For example, storms and floods could lead to poor crop harvests, and so higher prices for food. Or shipping delays or disruptions can reduce the availability of goods produced overseas, leading to higher goods prices. Once again, demand for goods will outpace supply, but in this case we call it cost push inflation.
We know how much prices have increased because of the Consumers Price Index or CPI, which we use to tell us how much prices have changed over the year. Stats New Zealand record the prices of food, clothing, transport, housing and about 100,000 different things you can buy or pay for. These are then combined to make up the CPI.
Our inflation calculator is an easy way to see how much prices have changed over time. We can look at specific areas of the economy as well as general price increases. Let's look at how the prices of goods and services have changed over the last 20 years or so. Using the calculator, we can see that a trip to the supermarket that cost about $100 in the year 2000 would have risen to $195 in 2023. In other words, for the same dollars your purchasing power has almost halved. On the bright side, wages have risen around 132%, So much more than food prices over this period.
Overall, the CPI, the overall basket of goods and services has increased about 82% since 2000. Roughly a 45% loss in purchasing power. So we care about inflation here at the RBNZ because high inflation and variable inflation comes with substantial costs to the economy and not a lot of benefits.
Our main tool to help keep inflation low and stable is the official cash rate, which influences how expensive it is to borrow money from the bank. When inflation is too high, we raise the cash rate so people spend less and save more.
This helps to balance demand for goods and services with supply. Low, stable inflation is the best contribution we can make as a central bank to ensure economic wellbeing and prosperity for all New Zealanders.
Stress tests
The Reserve Bank of New Zealand keeps a close eye on all banks to see how they would cope in stressful economic situations.
One of the ways we assess whether banks can stand up to possible financial or economic pressures is by running hypothetical stress tests.
Stress tests subject banks to hypothetical scenarios to see how they cope.
These scenarios are severe but plausible. Let's see how this bank copes.
What happens if there's a sharp drop in house prices? Or what happens if dairy prices take a hit? Or there's a spike in unemployment? Or how do they react if interest rates increase significantly? Or they all happen at once?
Stress tests let us see if banks can get through challenging times, while continuing to contribute to a sound financial system. Stress tests aren't pass or fail exercises. They're designed to help both the Reserve Bank and trading banks understand current and emerging risks, and find ways to mitigate those risks.
We also look at stress test results across all banks to see how the wider financial system might cope with financial stress.
These wider results consider how the collective actions of the banks could impact the overall system.
The Reserve Bank is committed to ensuring the financial sector remains sound and efficient, and stress testing is just one of the tools in our toolkit.
You can read more about the stress testing and recent system-wide test results in the Reserve Bank's Financial Stability Report.
Keeping banks healthy: How do we monitor the health of banks?
Every now and then we all need a check-up to make sure everything is working as it should. The same goes for banks.
Everyday, banks all over the country lend to borrowers who range from low to high risk.
So how do we ensure this risk is managed and the failure of a bank doesn't bring down the whole financial system?
Let's take dairy farmers as an example. We've seen dairy prices fall away in recent years, leaving farmers in tricky situations because their income drops away as well.
Farmers with more money in their farms, less debt and deeper pockets, can weather the storm better.
Banks need to have good lending practices so they can weigh up whether to lend to a customer or not. They need to be sure that their customer has enough money in their farm so that if they got into financial difficulty, that is, the price of milk went down, they would still be ok and it wouldn't put the bank at risk.
The work we do with the banks ensures checks are in place - much like a check up with your local GP.
We monitor banks, require them to show us their balance sheet so we can be sure everything's as it should be.
We check that banks have good overall health, have adequate and reliable funding, are resilient enough to withstand an event like the global financial crisis in 2008 and have a dashboard that shows all operations are working as they should.
New Zealand's banking system has been judged sound by the Reserve Bank and the International Monetary Fund, the global organization that monitors financial stability.
Global forces: Is New Zealand's economy safe from global shocks?
Natural disasters. Financial crises. Presidential elections. Brexit.
Just how safe is the New Zealand economy from global shocks? To answer that question, let's imagine the world economy is a vast ocean.
Our world is more connected than ever before. This means when someone makes a big splash in the water, the rest of us usually feel it.
Many global events are like slow-moving currents beneath the surface of the sea. We can see them coming and predict what's likely to happen by forecasting.
New Zealand's economy is sound, which means we can move with the currents relatively unaffected - go with the flow and ride the waves knowing we have the gear we need to keep us afloat.
But sometimes world events can send waves crashing on us unexpectedly. Events like the Global Financial Crisis can send us reeling.
So how do we prepare for those more turbulent swells?
We work to keep things stable like overall consumer prices and the value of our money, the stability of our banks and our access to cash, among other things.
By working with these tools the Reserve Bank plays its part in helping our economy to weather the storms. So despite some rough seas in recent times, our forecast remains sunny.
We live in a volatile world and changes are happening all the time, but wherever our economy goes our policies work to keep us stable.