Squirrel: What is the OCR and Why is it Important?

For Kiwi households with a mortgage, chances are the phrase ‘Official Cash Rate (OCR) announcement’ has become a bit of a stress trigger in recent times.

OCR announcements happen seven times per year like clockwork. It’s when the Reserve Bank of New Zealand (RBNZ) tells us whether our interest rates are going up, down, or staying put.

And for 20 long, gnarly months between October 2021 and May 2023, it was nowhere but up.

From a low of 0.25%, the RBNZ pushed through 12 consecutive hikes to the OCR to get us up to our current 5.5%, before finally hitting pause – and mortgage rates have gone from about 2.5% to over 7% as a result.

So, it’s safe to say that what the OCR is doing has massive consequences for Kiwi borrowers – and their wallets.

What is the Reserve Bank and its role in our economy?

Before we get into the finer details of the OCR, it helps to have a bit of background on the Reserve Bank and its role in our economy.

The RBNZ is New Zealand’s central bank, and its main job is to keep our financial system safe, stable and running efficiently.

That remit puts it in charge of all sorts of things, from producing our banknotes and coins, to regulating financial service businesses, such as banks and insurers, and – most relevant to what we’re talking about here – managing inflation.

As New Zealand is deep in a cost-of-living crisis, inflation has been a hot topic over the past couple of years. And, put simply, inflation is the pace at which the cost of items – like food, transport, housing and utilities – increases over time.

Inflation is driven by a combination of things, including demand for goods and services being greater (sometimes much greater) than the available supply, as well as input factors, such as wages, transport costs and raw materials.

The RBNZ’s target is to keep inflation somewhere between 1% and 3% over any given 12-month period, but that’s no easy task.

In the wake of the COVID pandemic, and the different monetary stimulus policies that were introduced to help keep the economy afloat as the world shut down, crucial parts of the supply and demand equation were thrown out of whack:

• Super-low interest rates meant people could borrow lots of money, really cheaply, sending demand for some goods and services through the roof – like we saw in the housing market, for example.
• Border closures led to significant labour shortages, creating a market in which employees had lots of bargaining power to negotiate higher wages, driving up the cost of labour.
• Problems in the global supply chain meant that it wasn’t as easy to move manufactured goods and raw materials around the world – creating supply shortages like the ones that hit our construction sector, hard, and drove up costs there.
• Geopolitical events, like the war in Ukraine, also contributed to disruptions in things like the supply of oil, driving prices up there, too.

It was a perfect storm that caused inflation to climb steadily, ultimately hitting 7.2% in the 12 months to June 2022.

And the Reserve Bank has been battling to get inflation down to its target levels ever since.

What is the OCR, and how does it work?

The OCR is the interest rate that banks earn on any money they’re holding with the Reserve Bank, and the rate they pay to borrow funds. Think of the Reserve Bank as the banks’ bank.

The OCR is also a big lever that the Reserve Bank can pull to control inflation, making it rise or fall.

When the OCR goes up (or down) it directly impacts banks’ interest costs, making it more (or less) expensive for them to borrow money. And, just like lots of other businesses, the banks pass these borrowing costs down the line to their own customers in the form of higher/lower lending rates – and, equally, higher/lower deposit rates.

So that’s why when the OCR moves, mortgage rates follow.

It’s worth noting that the most important thing when it comes to fixed home loan rates is what the markets anticipate will happen to the OCR. That’s why fixed home loan rates may move even if the OCR hasn’t. Meanwhile, for floating rate mortgages, the link to changes in the OCR is pretty tight.

How does a higher OCR, and higher interest rates, help to bring inflation under control?

It’s like we mentioned above; when interest rates are low (like they were at the height of the pandemic), it makes it really cheap for people to borrow money to buy things – and that, in turn, drives demand in the economy.

In this scenario, inflation is what happens when the supply side of the equation doesn’t, or can’t, grow to match demand.

When it hikes up the OCR, the Reserve Bank knows these increases will be passed on to customers in the form of higher interest rates. And higher interest rates mean:

1. People will be less inclined to borrow money, because it’s more expensive
2. People with existing debt have to dedicate more of their discretionary income to afford their repayments as interest costs go up. For homeowners, in particular, with mortgages worth hundreds of thousands of dollars, the consequences can be brutal.

Both of these factors can help to take heat out of the economy, because people have less to spend elsewhere. Demand then falls back more closely in line with the supply side of the equation, and that helps to bring inflation back down again.

The OCR is a blunt instrument, and wielding it is a tough gig

The nature of interest rates, especially as far as mortgages are concerned, means that it takes a while for changes to the OCR to trickle through to the economy.

In a high-OCR environment, it’s only as mortgage borrowers come to the end of their existing fixed-rate term (and have to roll over to current rates) that they start to feel the pinch.

Right now, anyone who opted to lock in their mortgage long-term back when rates were at record lows, still may not have felt the impact more than two years after increases began. While others will be facing the prospect of their second rollover since rates started to climb, now looking at even higher rates than last time.

This delayed flow-on effect means it’s a pretty tough balancing act for the Reserve Bank to get right. It often faces criticism for waiting too long to hike rates when inflation rears its ugly head, and too long to drop rates again once inflation is back under control.

Safe to say, we don’t envy the Reserve Bank the job of having to strike that balance.