For Kiwi households with a mortgage, the "Official Cash Rate (OCR) announcement" is likely to induce stress. The Reserve Bank of New Zealand (RBNZ) issues OCR announcements seven times a year, informing us whether interest rates will increase, decrease, or remain stable. And for a shocking 20 months from October 2021, it skyrocketed like a firework show.

Between October 2021 and May 2023, the OCR rose steadily over 12 consecutive hikes increasing from a low of 0.25% to the current 5.50%. Consequently, mortgage rates have risen from about 2.05% to 7.25% (or higher) so it’s safe to say that the OCR has significant consequences for Kiwi borrowers and their financial well-being.

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Let's take a closer look at the Reserve Bank and its role in our economy.

The RBNZ is the Central Bank of New Zealand, and its primary responsibility is to keep the financial system safe, stable, and efficient. This involves a variety of functions, ranging from producing banknotes and coins to regulating financial service businesses such as banks and insurers. The RBNZ's most important function, however, is managing inflation.

Inflation, or the rate at which the cost of goods such as food, transportation, housing, and utilities increases over time, is affected by a variety of factors, including greater demand, supply chain disruptions, and input factors like wages and raw materials. The RBNZ's target is to maintain inflation somewhere between 1% and 3% across any 12-month period, however, this is not a simple job.

Inflation has been a hot topic over the last few years due to New Zealand's cost-of-living crisis, which has been exacerbated by the COVID-19 pandemic and the various monetary stimulus policies introduced to keep the economy afloat by the Labour Government.

The perfect storm of low-interest rates, border closures, labor shortages, and supply chain disruptions has caused inflation to rise steadily, reaching a peak of 7.2% in the 12 months to June 2022. The Reserve Bank has been working hard to bring it back down to target levels since then, and let’s be honest it’s still a work in progress. 

So, what exactly is OCR, and how does it work? 

The OCR is the interest rate that banks earn on money they hold with the Reserve Bank and the rate they pay to borrow funds. As the "bank of banks," the Reserve Bank leverages the OCR to manage inflation by increasing or decreasing it as necessary.

When the OCR changes, banks' interest costs are directly impacted, which causes them to adjust their lending rates and deposit rates. This means that fluctuations in the OCR will invariably affect mortgage rates as well.

It's important to mention that one of the most important factors that impact fixed home loan rates is what the market predicts what will happen with the OCR. It's almost like a weather forecast, influenced by what the market thinks might happen to the OCR, which means rates could change even if the OCR hasn't budged yet. On the other hand, floating rate mortgages are like besties with the OCR, moving in sync with all the changes.

But how does a higher OCR and higher interest rates help control inflation? 

When interest rates are low, people can borrow money cheaply, which, in turn, drives demand in the economy. Simply put, when the demand for goods and services outpaces the supply side, inflation sneaks in like a sly fox.

When the OCR is raised, the Reserve Bank knows those increases will be passed on to customers in the form of higher interest rates. Higher interest rates mean:

1. That people are less inclined to borrow money because it's more expensive to do so. 
2. Most people will need to dedicate more of their spending money that used to be earmarked for other things, towards their mortgage payments - meaning they have less to spend on things like entertainment, shopping and daily living expenses. For homeowners, especially those with mortgages worth hundreds of thousands of dollars, when existing debt demands extra cash and you're left scrounging to afford bigger payments, the consequences can hurt!

Both of these factors help to take heat out of the economy, reducing demand and bringing it back in line with the supply side of the equation, helping to lower inflation.

It's worth noting that OCR is not a precise tool, and it takes some time for its effects to trickle down into the economy, particularly where mortgages are concerned. It's only when customers have lending coming up for renewal that they really experience the impact - for instance, those who fixed at record lows two plus years ago at 2.25% and aren't refixing until late 2024, means they wouldn’t have felt the pinch from the previous rises yet. This delayed flow-on effect poses a challenge for the Reserve Bank to balance its decision-making, and they are often criticized for taking too long to raise rates when inflation becomes an issue, and too long to lower rates again once inflation subsides - a tricky balancing act to pull off!