What the OCR Means To You

A change in the Official Cash Rate can leave you feeling a bit richer or a bit poorer depending on which way the pendulum has swung.

Money in the bank when the rate goes up is good news. A floating mortgage rate when the rate goes up is bad news.

Generally, when the OCR goes up ordinary banks - the BNZ, ANZ etc - also raise their short-term interest rates. So do other financial institutions like building societies, funds managers and finance companies. For the technically minded, the Reserve Bank acts as bank to the banks and the OCR is the rate that the Reserve Bank is prepared to lend to and borrow from banks overnight.

For savers an OCR increase is good news. The interest rates paid on many savings accounts go up, boosting savers' incomes. Later on interest rates offered on other fixed interest investments - term deposits, bonds, debentures etc - may also rise depending on perceptions of longer-term trends including inflation.

For many borrowers, however, higher interest rates are bad news because they must pay more interest. That means their regular repayments must rise, or they must spend longer paying off the loan. If you are on a fixed mortgage then you may well be feeling rather smug! You are no better off in absolute terms, but you are better off relative to people with floating mortgages.

So why does the Reserve Bank tinker with interest rates?

Because that's how it keeps inflation under control.

Keeping annual inflation between 1% and 3% is one of the Reserve Bank's main jobs. Inflation happens when demand in the economy for goods and services exceeds supply. Prices start rising and money starts losing its value. If prices rise faster than wages people are left worse off.

Likewise, disinflation occurs when the rate of inflation starts to fall. If unchecked, this can lead to deflation when average prices are actually falling. Then money is gaining in value and, depending on the cause, often deflation is associated with an economic contraction and rising unemployment.

The Reserve Bank controls inflation using interest rates. To rein in inflation the Reserve Bank has to discourage people from spending. The way it does that is by getting banks and other financial institutions to increase their interest rates. Higher interest rates encourage people to save more because their savings will earn more interest. Higher interest rates also discourage people from borrowing more because interest repayments are higher. As people save more and borrow less the pressure on prices eases, and inflation falls.

Likewise, if there is a risk of inflation falling too low (below 1%) then the Reserve Bank reduces the OCR, leading to lower short-term interest rates, more spending in the economy and inflation rising again.

To get banks and financial institutions to raise or lower their interest rates the Reserve Bank uses the OCR. The Reserve Bank sets the level of the OCR. Banks and financial institutions then use the OCR as the starting point to set many of their own interest rates, particularly home lending rates. So when this starting point goes up or down, the interest rates offered by banks and other financial institutions also tends to go up or down.