Why is the Reserve Bank Raising Interest Rates?

Why is the Reserve Bank raising interest rates? The short answer is to get inflation down!

Imagine trying to throw a dart at a dart board to hit a certain number, whilst the dart board is constantly turning, the rate of the spin is constantly changing, and the dart could take two years to hit the board!

That’s what the Reserve Bank has to do!

Under the 1989 Reserve Bank Act, the Reserve Bank is required to operate monetary policy to achieve and maintain price stability and to support maximum sustainable employment.

Basically, monetary policy works by encouraging or restraining growth of overall demand for goods or services in the economy. When overall demand slows relative to the economy’s capacity to produce goods and services, unemployment tends to rise and inflation tends to decline.

The Reserve Bank’s target range for inflation is 1% -3%. Inflation in New Zealand is currently running at about 7%. Clearly the Reserve Bank has work to do.

One of the main levers the Reserve Bank pulls to get inflation back within its target range is to increase the Official Cash Rate (OCR). The OCR is the interest rate set by the Reserve Bank. It is, in effect, the wholesale price of borrowing or lending money in New Zealand. It influences all other interest rates such as Mortgage, Hire Purchase, Credit Cards and consumer lending rates as well as interest rates received on your savings in the bank.

By putting up interest rates the Reserve Bank is trying to reduce household spending which in turn will discourage business from increasing their selling prices which is where inflation comes from.

When interest rates rise borrowing money for purchases costs more, when mortgage interest rates rise your repayments go up, and you have less to spend on other things, which reduces consumer demand.

Of course, in the real-world things do not always go to plan and New Zealand is a small country in a big world. Global developments have a big influence on the New Zealand economy and are largely outside of the Reserve Banks control.

It can take a long time for any changes in the OCR to affect the economy and inflation, anywhere from three months to two years. This means the Reserve Bank is not looking at what the inflation rate is now, but what it will be in two years’ time, and a lot of things can change during that time.