Why the official cash rate is important

Reserve Bank Governor Adrian Orr is poised to raise the official cash rate (OCR) to new heights on Wednesday, with pundits predicting the sharpest-ever rise as the central bank continues its campaign to slow the inflation rate.

Orr, in the bank’s final monetary policy statement of the yearis predicted to raise the OCR – the rate at which the central bank lends money to commercial banks – by 75 basis points to 4.25%.

Any move will likely influence the price of borrowing money in New Zealand because it will cost commercial banks more to borrow, a cost it will pass onto customers.

But it is another short-term financial pressure on households already paying more for everyday items as a result of rampant inflation, now at 7.2%as it means people will be left with less money once they have serviced their debts.

Inflation is taking hold worldwide, including the US and the UK, in no small part because of the war in Ukraine. It has created supply chain disruptions and driven up the cost of raw materials, commodities, energy and transport.

The bank warned in its August monetary policy statement that interest rates will rise further as it seeks to get inflation back into the 1 to 3% target band.

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Reserve Bank Governor Adrian Orr is tipped to raise the official cash rate on Wednesday.  (File photo)

ROBERT KITCHIN/Stuff

Reserve Bank Governor Adrian Orr is tipped to raise the official cash rate on Wednesday. (File photo)

What will happen?

At 2pm on Wednesday, the Reserve Bank will publish its review of the OCR, as well as its final monetary policy statement of the year.

Whether commercial banks raise their interest rates in response is not a given because banks get their money from a variety of places, including overseas markets.

They are also competing among themselves for people to bank with them, so they want to charge attractive rates.

Banks pass increased borrowing costs onto consumers.  (File photo)

Kirk Hargreaves/Stuff

Banks pass increased borrowing costs onto consumers. (File photo)

Changes to the OCR influence short-term interest rates more than other types, because a bank is likely to have considered future OCR hikes when it is setting longer-term interest rates.

It reviews the OCR seven times a yearand issues a monetary policy statement every three months. Raising the OCR is one of the ways the Reserve Bank tells the markets how it sees the trajectory of the economy.

Orr also uses official statements, economic projections, speeches, interviews and news conferences to influence what happens in the markets.

Does the OCR hike only affect people with loans from the bank?

Changes to the OCR influence every corner of the economy. It affects people’s spending habits and behaviors and whether they are more likely to spend or save.

This adds or lessens pressure on the economy, and has an impact on employment and inflation – and everyone is affected by inflation, a measure of a general increase in prices and fall in the purchasing value of money.

The higher cost of money reduces your purchasing power – what you can afford to buy. By raising the OCR the Reserve Bank is effectively making you buy less, which it hopes will bring down inflation.

How does the OCR influence inflation?

Raising the OCR is one of the Reserve Bank’s tools to control the economy. Inflation is high at 7.2% now, which means you would need to spend $107.20 to get what would’ve cost you $100 a year ago.

By making it more expensive to borrow, the bank hopes it will slow consumer and business demand. Put simply, higher interest rates are likely to re-balance the relationship between supply and demand, lowering the rate of inflation.

Inflation occurs when people have a lot of cash and not that much to spend it on, because they often bid up prices. If people are spending more money on their debts, and it is more expensive to borrow money, they will have less money to spend on other things.

The Reserve Bank has already raised the OCR by 50 basis points five times this year, as well as a single 25bp raise earlier in the year.

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