What is the OCR and how does it move mortgages?

Some Northland homeowners are having to make financial sacrifices like selling off their boats and family cars as interest rates soar. Photo / file

All eyes are on the Reserve Bank today as it decides where to set the Official Cash Rate (OCR).

If it goes up, then so, too, will mortgage rates (or your savings deposit rate). If it goes down, then your mortgage rate or deposit rates should also follow.

At least that’s how it should work in theory. Unfortunately, things are seldom quite that simple.

So first...

What is the OCR?

As a working definition, we can think of the OCR as the wholesale price for lending and borrowing money.

It’s the baseline interest rate, the starting point for banks before they add their margins.

How the Reserve Bank (RBNZ) controls that rate is where it gets more technical.

The big retail banks hold accounts with the RBNZ and these accounts are used to settle transactions at the end of the day.

When you buy something electronically, there’s usually a transaction between two banks that needs to be settled.

The accounts with the RBNZ are used to cover transactions that haven’t yet been matched up at the end of the day.

By fulfilling that function, the RBNZ can both charge and pay interest. And by doing that, at the lowest available domestic rate, it effectively sets the floor for all other domestic interest rates.

How effective is it?

There’s clearly a strong correlation between the OCR and bank rates - as anyone who has refixed in the past six months will have felt.

It certainly does the job of setting the general price conditions for the cost of borrowing.

But the extent to which it works and the speed at which it works are difficult questions to answer precisely.

The RBNZ has done - and continues to do - extensive research assessing how the effects flow through (what they call transmission) from the OCR to bank rates.

RBNZ research in 2021 found a 1 per cent change in the OCR typically moves average two-year mortgage rates by 0.34 per cent within one month.

The pass-through from changes in monetary policy increases over time, with the peak impact on mortgage rates about six months after the change in the OCR.

At that point, about 80 per cent of the initial 1 per cent change in the OCR is typically passed through in higher or lower mortgage rates.

One factor limiting the direct impact of the OCR is to do with the amount of funding banks get from offshore markets, as opposed to local deposit-taking.

The more international funding they use, the less they need to rely on the local rate. However, high levels of international funding also make banks (and Kiwis) more vulnerable to global financial shocks. After the Global Financial Crisis in 2008, the proportion of funding banks could source from offshore was limited.

The time it takes the OCR to shift rates is affected by the way we borrow from the banks, ie how many people float their mortgage, how many fix their mortgage... and how long they fix for.

If, like a lot of Kiwis, you fix your mortgage for a year or two, then you won’t feel the OCR change until you refix.

When you do refix, longer-term rates will price in what the bank thinks interest rates will do across that period. Shorter-term rates are more likely to be closer to the OCR.

In Australia, a lot more of the borrowing public keep their mortgages floating - so the official cash rates transmits much faster.

In the US, it is a wonder it transmits at all - it is common there to fix a mortgage for 30-year terms.

How much short-term funding banks use and how much long-term funding they use can also affect the rates they offer relative to the OCR.

What about bank competition (or lack of it?)

The margins banks charge above the OCR are always contentious. If there is a lot of competition, then they may be forced to reduce the margin and the bank rates should be closer to the OCR rate.

If competition is lacking, then they’ll have space to charge more.

Despite concerns about a lack of competition, there is clearly some price tension in the market. We see that when banks move rates on or shortly after an OCR decision. The real costs haven’t passed through at that point but banks often use the extra public attention on rates to maximise the marketing power of a timely move.

Okay, that’s the OCR... but why do we sometimes talk about the MPS?

The Reserve Bank makes an OCR call roughly every six weeks at a Monetary Policy Review (MPS). But just to confuse things, every three months the review is part of a broader MPS.

So there’s always an OCR decision at an MPS but there isn’t an MPS with every OCR decision.

The MPS includes a lengthy written analysis of the economy and how it is looking to the RBNZ and a fresh set of economic forecasts.

Today, we’ll get the February MPS as well as the latest OCR decision.

That makes it especially exciting to economists and business journalists. To join the excitement, tune in at 2pm for full coverage.

Liam Dann is Business Editor-at-Large for the New Zealand Herald. He is a senior writer and columnist, and also presents and produces videos and podcasts. He joined the Herald in 2003.

For more from Liam Dann, listen to his podcast Money Talks