The 12 month rate fix (part 1)

Housing Market Written by Ben Pauley, Oct 10 2018

12 Month interest rates are particularly appealing at the moment. Kiwibank has most recently offered a 12-month fixed rate sub 4% and many banks are moving in the same direction. This is fantastic for the next 12 months, however it pays to think about what you are going to do post the expiry of this rate.

With that in mind, we’ll explore the following five key points over two parts:

  1. What is the Official Cash Rate and how is it applied?
  2. What is inflation and why is it important?
  3. The connection of interest rates to inflation.
  4. Forward interest rates and how they are calculated.
  5. Current Inflationary drivers in NZ.

Firstly, what is the Official Cash Rate (OCR) and how is it applied?

The OCR is the interest rate for borrowing or lending money for banks in NZ set by the Reserve Bank of NZ (RBNZ). Each bank in NZ borrows or loans (deposits) money from or to the RBNZ based on this rate.

Each NZ bank holds a settlement account with the RBNZ. These accounts are used at the end of each day to settle the transactions between each bank. Effectively, at the end of each day all the banks do a wash up of the transactions that have occurred throughout the day paying away the funds they need to the other banks and receiving what is owed.    

Occasionally banks end up needing to pay more than they receive, and they utilise all the cash in their settlement account. In these instances, they borrow cash from the RBNZ or each other based on the OCR. Those banks that have cash surplus to requirements can deposit funds with the RBNZ or lend to another bank at a rate based on the OCR.

Thus, the OCR directly impacts banks interest rates as it formulates a large cost of funding for banks (alongside offshore and deposit funds). 

Now let’s talk inflation and why it’s important.  

Inflation reflects the speed at which money changes hands in the economy. This is further demonstrated by the change in prices in the economy, increasing prices being inflation. Decreasing prices equal deflation. The RBNZ is tasked with keeping inflation between 1 - 3%.

Inflation is important as it drives people to spend money.

If you have $1.00 today to spend and if you are aware that the item you want to buy will cost $1.00 today but $1.05 tomorrow you are more likely to spend that dollar today.

Conversely, if you have $1.00 today and you expect the item you want to buy to cost $0.95 tomorrow you may wait before spending that dollar. If you continue to wait, the economy will slow as people would not spend money (trade).

High levels of inflation, however, are detrimental. Saving is important in an economy as it leads to capital investment (in property, machinery and other goods that generate further income) and if inflation is too high people will not save. Investment will slow or cease, and productivity will follow.

Having a target of 1-3% for the RBNZ is therefore important as it provides balance. Inflation is high enough that people are encouraged to spend but not so high that they also save some of their funds.

There are many instances of extremely high inflationary environments, most of which lead to disaster. I recommend reviewing Germany in the years following WW1 or Argentina in the 1980’s or Venezuela right now.

Lastly, for part 1, we discuss the link between inflation and interest rates.

Interest rates are a tool to control inflation. When inflation is high, interest rates rise to slow spending and when inflation is low interest rates are low to spur spending.

Interest rates affect people’s borrowing capacity (lower interest rates make borrowing easier to repay). Borrowing money is spending your future income today. Interest is the cost of using this income today and therefore lower interest rates reflect a lower cost of that future income.

People’s borrowing capacity impacts their spending capacity and thus lower interest rates could lead to higher inflation.

The RBNZ influences interest rates as mentioned earlier through movements in the OCR.

Next month, in part 2, I will comment on how forward rates (future interest rates) are discovered  and what inflation drivers are seen in the NZ economy at the moment. I will  put this all together with my thoughts on fixing for 12 months .

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