You may have wondered why economists, the media and your financial adviser get all excited about official cash rate announcements!
The official cash rate is set by the Reserve Bank of New Zealand. It is one of the tools that the bank uses as part of its monetary policy operations.
The Reserve Bank has the mandate of operating and achieving price stability (managing inflation) and supporting maximum sustainable employment (keeping the economy operating at an optimal level).
The official cash rate is a strong influence on the rates set for borrowing money in New Zealand.
All registered banks operating in New Zealand have an overnight settlement account with the Reserve Bank. All money being passed from one bank to another is passed through the settlement accounts with the Reserve Bank, which can amount to millions of dollars every day. The interest rate of these overnight clearance accounts is tied to the official cash rate. Banks either have to pay the interest or receive the interest, depending on whether they end up with a credit or a debit balance.
Banks also borrow money from the Reserve Bank. If the official cash rates increases, it costs a bank more to borrow money so the bank passes the increased cost onto their customers in the form of higher interest rates. A change in the official cash rate is usually immediately passed through to floating mortgage rates, and then onto new fixed interest rates over the next few days.
The theory behind the official cash rate as a lever to control the economy is that higher interest rates lead to people having less disposable income, they then buy fewer goods and a lower demand for goods lowers the rate of inflation. It also works the same in reverse – a lower interest rate means that people will spend more, stimulate the economy and an increased demand for goods will increase inflation.
Higher interest rates to borrow money also affects business investment. If the cost of borrowing increases, businesses need to look at the return on investment. If a business borrows at 5% to invest in a piece of machinery that will have a 6% return to the business, they would probably think very carefully before they make that investment. Higher interest rates can slow down any potential expansion plans of a business where they are borrowing to expand, and consequently can tighten up future employment rates as the business will not be increasing its work force.
On the positive side, a higher official cash rate can lead to higher short term deposit rates and higher rates on savings accounts. However, long term rates are normally more closely aligned with bond yields, and bond yields are priced by financial markets. When a bank offers a rate for a term deposit, they are taking money from investors to lend to others i.e. borrowers. If there is no demand to borrow money, banks will not be keen to attract deposit money and will not offer good term deposit rates. If you watch interest rates closely, you will see often that a bank suddenly seems to back off on its term deposit rates and this is usually because they have a surplus of funds available to lend at that time.
There is a lot of information about the Official Cash rate available on the Reserve Bank website, including this video:
Janet Natta is a financial adviser and director of Smart Money Advice, offering investment portfolio construction and management services to clients throughout NZ, as well as comprehensive financial planning advice to assist clients to build and protect wealth to achieve their dreams.
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