In August 2019, the Reserve Bank announced that it was dropping the Official Cash Rate (OCR) to the lowest it’s ever been...1%.
Does that look like gibberish to you? Don’t worry—you’re not alone. Let’s work out what the OCR is, and what it means when it goes up or down.
The Reserve Bank is a government organisation whose job is to keep an eye on the banks, and make sure prices are stable.
One of the Reserve Bank’s jobs is to take care of overnight settlement. Every day, there are millions of bank transactions—you swipe your EFTPOS card to buy a coffee, you do a bank transfer to pay your rent, and so on and so forth for everyone in the economy.
The money you spent on the coffee goes into the cafe owner’s bank account; the money you spent on rent goes into your landlord’s bank account. Then it might move around some more, as the cafe owner and your landlord buy things they need.
At the end of the day, the banks need to settle up with one another to balance out all these transactions. And things never match up properly. Some banks will have more than they need to pay everyone they owe, and other banks will have less than they need. That’s where the Reserve Bank comes in. The banks that have more cash than they need can deposit their extra money in the Reserve Bank overnight; the banks that need more cash can borrow money from the Reserve Bank overnight. They don’t have to do this (they can borrow from one another), but they have the option.
Since they have the option of borrowing from the Reserve Bank, they are effectively limited on how much they can charge one another. After all, you wouldn’t pay another bank 3% to borrow some money when you can just pay the Reserve Bank 1%.
Why oh why?
You might remember from our post a while ago that inflation is the steady increase in the price of things we buy. We can generally rely on inflation growing by a small, predictable amount every year. This is thanks to the Reserve Bank.
If the economy is left to its own devices, prices can lurch around pretty dramatically. When things are booming, prices start to shoot up; when things are getting a bit crunchy, prices start to fall. This can be a real pain for everyone. Imagine if the price of your fuel and groceries went up by 20%, but your salary stayed the same!
So the Reserve Bank uses the OCR to smooth out these booms and busts. By raising or lowering the OCR, the Reserve Bank can influence people’s behaviour—including yours when you buy that coffee!
Here’s why: a low OCR means low interest rates on both bank deposits and loans. Since the OCR is currently 1%, both mortgage rates and deposit rates are very low. This encourages people to spend and borrow. After all, if the interest you get from a bank account is very low, you may as well just spend that money instead. What’s more, if you can get a loan at a really low interest rate, then it’s easy to make the repayments. These two things encourage people to spend and borrow instead of save and pay down debt.
This is very deliberate. The Reserve Bank does this when they think the economy could use a little boost. When people are spending instead of saving, that’s more money going into business owners’ pockets. That might make those business owners keen to expand and hire more staff—especially because it’s also cheaper to borrow money!
The reverse happens too. If everyone’s having a bit too much of a party, and things are growing really quickly, the Reserve Bank cranks up the OCR to pour water on everything. By encouraging people to save and pay down debt, rather than spend, the Reserve Bank can (theoretically) slow down runaway growth.
The OCR and shares
The Reserve Bank lowers the OCR to try to increase inflation. Since inflation is the increase in the price of things, this includes shares. Let’s say you have $100 to invest, and you want a 6% return. If term deposit rates are 6%, then you can just bang the whole thing in a term deposit and forget about it.
Now let’s say term deposit rates drop to 4%. You’re not going to get that 6% return by putting your entire $100 in a term deposit. To get those 6% returns, you’ll have to invest some, or all, of your money in something riskier, like shares. The more the term deposit rates drop, the more of your money you’ll have to invest in riskier things.
By the time rates get down to 1%, you’ll be investing a really large chunk of your $100 in shares. And you’re not the only one doing this! KiwiSaver providers, other investors, big fund managers—even ACC and the NZ Super Fund will all be doing the same thing. But the number of shares available to buy hasn’t really increased by much, if at all. So the price goes up.
In the long term
The OCR is all about the short and mid term. The Reserve Bank expects the economy to grow and shrink over time, regardless of what decisions they make with the OCR. The OCR just makes that growing and shrinking less jarring.
This means that if you’re investing for the long term, you don’t really need to think about the OCR. If the OCR is low when you start investing, odds are it will be high at some point in your time horizon, and vice versa.
So while it’s useful to understand the OCR, and the impact it has on the economy, you probably don’t need to concern yourself with it if you’re investing for the long term. Just like share prices, the OCR goes up and down over time, so the best thing you can do is just ride those movements out.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written