Reserve Bank Governor Adrian Orr announces the OCR cut to 1% on August 9. Photo: Getty

What the Reserve Bank's Official Cash Rate cut means: A guide for dummies

The Reserve Bank cut the Official Cash Rate (OCR) to a historic low of 1% last week, but what does that actually mean? Is it to do with whatever's going on between China and the US? Is a recession around the corner? And does any of it relate to the huge financial loss Fonterra announced yesterday? Economics idiot Tess Nichol has absolutely no idea. So she asked her dad, business journalist Pattrick Smellie, to explain.

Tess: Hi Dad!

Pattrick: Hi T.

Ok, so - the Official Cash Rate (OCR) cut. What does this actually mean? I know it’s good if you have a mortgage, but what does it mean for me or people like me - aka renters with few savings?

It probably doesn’t mean much for renters with little savings. The market pressures that are sending rents so high are not so much to do with interest rates as scarcity of rental properties and the very large mortgages that some landlords are servicing to buy the houses they’re renting.

For people like me, people with no mortgage and some savings, it means that putting money in the bank is even less attractive than it was before.

The Reserve Bank hopes this will tempt some people to spend more and plump up the NZ economy, which is slowing down.

Or, alternatively, that people will put their money into more productive investments, which are generally higher risk, rather than putting money in the bank, again to stimulate the economy. That’s the theory, anyway.

What actually is the OCR?

Every night, there’s a banking system process known as ‘settlement’ in which the trading banks (like BNZ or Westpac) are required by law to deposit money with the Reserve Bank overnight for distribution to other banks, based on whatever transactions all their customers undertook during the day. There’s always a few billion dollars slopping around heading from one place to another. 

The OCR is the interest rate that the Reserve Bank pays to the trading banks for holding that money overnight as a cash deposit. Think of it like this – if you put money in your savings account, you get to collect interest from your bank. The same principle applies here, even though the money is only with the RBNZ for a night. The benefit for the RBNZ is this way they get oversight on what the trading banks are up to, and access to money which can be put on deposit elsewhere (like international money markets), to generate revenue for the RBNZ. 

As a result, the OCR sets the benchmark for the interest rates that the trading banks charge on loans or pay for savings.

Don’t cash rates get cut when the economy is in trouble? This won’t surprise you, but I'm getting anxious about stuff, particularly another recession, and the possibility of losing my job right about when I want to start planning a family.

How do I answer this simply? There are a few factors at play:

1. Central banks don’t always cut interest rates because there’s trouble ahead, although sometimes that’s the case. The OCR fell from above 8% at the time of the Global Financial Crisis (GFC) to 2.5% in less than a year. That is absolutely unprecedented and indicates the scale of the GFC’s impact.

The reductions since then, down to the current 1%, have taken a decade to occur.

2. Mostly, they cut interest rates to try to encourage inflation. The weird thing about the global economy at the moment is that inflation seems to have disappeared. High inflation used to be the biggest economic problem. Now it’s the absence of inflation.

So cutting rates is meant to make it more likely people will borrow and spend and inflation will rise. With so little room between 0% and the current OCR, however, that’s becoming difficult. I.e., the Reserve Bank has very little room to manoeuvre when it gets this close to zero.  When the OCR was at 8%, they had lots of ammunition to push rates up or down. At 1%, they have very little capacity to go lower, unless they start paying negative interest rates, which some people are starting to talk about.

3. Sometimes, the intention is to send the NZ dollar lower, because that acts as a cushion for exporters. When the dollar’s down, we get more for our exports in other currencies. However, it also pushes up the cost of imports, particularly fuel. In this case, I think there has been a desire to see a lower NZ dollar because the NZ economy is slowing.

4. As far as recessions go, two thoughts:

Recessions in economies are part of life. Economies tend to move in cycles and the amazing thing about the last 10 years since the GFC is that there hasn't been a recession. It’s been a particularly long period of growth.

But I don’t see NZ heading into recession - where the economy actually shrinks. Rather, NZ is heading into a period of slower growth, but still growth. The elderly and infirm, such as myself, remember when 2% GDP growth was a pretty good year. These days, it’s regarded as rather sluggish, but it’s still not bad and quite a bit stronger than most of our rich country peers.

If this cut fails to stimulate the economy, then what happens? Are we in trouble? 

We have high levels of household and farm debt, which is worrisome if interest rates were ever to rise much. But the government’s books are almost absurdly strong. We have some of the lowest government debt levels in the OECD. In the event of a recession, that gives the government room to spend more and ‘lean against’ economic bad times.  Not many other countries have that luxury.

And are you saying boom and bust is just… an unavoidable fact of life? What about everyone who’s the victim of that though? It doesn’t seem fair.

Governments can try to make economies fairer, but economies do tend to wax and wane. Some of it we can’t control. If there’s a long drought or something like that, an economy with a lot of exposure to agriculture will do worse. In a good year, it will do better. Things get a bit tighter for a while, then they get a bit better. The issue at the moment, I fear, is that governments (and central banks, not that they would admit it) have become so politically fearful of allowing a recession to occur that they are committed to endless growth, using increasingly experimental policies. The potential for that to create an even bigger bubble to burst down the track is a real concern. However, in NZ, there isn’t much sign of that. 

What are the chances of interest rates rising again, and saddling those with floating mortgages with more debt than they can repay? Relatedly, if markets are cyclical, when will the Auckland housing market experience a bust to balance the boom of the 15 or so years? Or have external factors broken the cycle? TL;DR: if you can’t afford a house now, will you ever be able to afford a house?

There’s some global consensus that we are stuck with very low interest rates for a very long time. If they did rise, it would hurt anyone on a very big mortgage quite quickly. However, no one I talk to sees interest rates jumping back to an OCR of 8% or anything like it in the foreseeable future - i.e., the next decade or more. They could be wrong, of course, but it’s really hard to see.

Bear in mind two things:

1. Not everyone borrowed for their house during the latest boom - only a proportion of borrowers have huge mortgages (and many people either bought in other centres or have moved out of Auckland to find somewhere less expensive).

2. Very low interest rates make it possible to service a very large mortgage. When we bought the house you were born in, we borrowed about $100,000, but interest rates were 20% a year. That’s equivalent to borrowing $500,000 at 5% today.

On Auckland house prices, they have already settled back quite a bit in the last year. This is the preferable way for a boom to end - with a slowdown and some backtracking, rather than a bust. 

I would be more concerned about an earthquake or volcano causing a property price bust in Auckland than interest rates or, if you own property on a beachfront, a collapse in demand and insurability as climate change bites.

Does this have anything to do with uhhh…. China and stuff???

It’s got heaps to do with China and stuff. The US has precipitated a trade war with China that is causing global trade volumes to fall and investor confidence in the world’s two largest economies to falter. That’s one of the biggest drivers of the gloomy sentiment around the world. If and when that gets worse, it will affect us. We’re too small for it not to. I remain an optimist that we have our economy in reasonable shape to deal with it.

Ok, so no need to freak out just yet. Also - what’s all of this got to do with Fonterra’s massive losses?

There’s no particular link to Fonterra’s troubles. The losses foreshadowed today relate to writing off the value of various dud investments they made under the previous board and management rather than economic fundamentals.  If you ignore the value destruction on their balance sheet, their day-to-day earnings look respectable. In a way, what Fonterra is doing with these writedowns and losses is a recession in microcosm - they’re clearing the decks of dead wood that’s never going to spring back into life. Once they’ve done that, the underlying business should be stronger and bounce back healthier as a result of the cleanout. (Yay capitalism…)

Thanks for explaining! Love you x

Love you too.

Pattrick Smellie is a founder and business journalist at BusinessDesk, with more than 35 years' experience in journalism and corporate public relations. He's also Metro digital editor Tess Nichol's dear old dad.

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