Thursday, January 26, 2012

New Zealand Reserve Bank Holds Interest Rates Steady

Reserve Bank of New Zealand: What is the Official Cash Rate?

On Wednesday, the governor of New Zealand’s Central Bank, Alan Bollard, announced that the Central Bank will hold the Official Cash Rate (New Zealand’s base interest rate) at a record-low of 2.5%, the rate it has been at since March 2011. Mr. Ballard cited weak economic growth due to worsening global economic conditions and lower than expected inflation in the fourth quarter of 2011 as reasons to keep the OCR at 2.5%.

In New Zealand, commercial banks hold accounts at the Central Bank which they use to pay the money they owe to other commercial banks after exchanging assets throughout a business day. The Central Bank pays commercial banks the OCR—currently 2.5% interest—on the amount of money a commercial bank has in its account, and charges the OCR if a commercial bank needs to borrow money to pay other commercial banks it traded with throughout the day. For example, if Bank A sold Bank B $200,000 worth of bonds, Bank B may have to borrow money from the Central Bank to pay back Bank A; the Central Bank would charge the OCR, or 2.5%, on this borrowing.

Although the OCR does not dictate market interest rates in the New Zealand economy, it has a strong influence. As an illustration, commercial banks may find it difficult to lend money at interest rates higher than 2.5% because other banks, which can cheaply borrow money from the Central Bank at a 2.5% interest rate, will quickly undercut an interest rate higher than 2.5%. Alternatively, a commercial bank is not likely to lend money at an interest rate lower than 2.5% because it could receive 2.5% interest by keeping its assets in its account at the Central Bank. Therefore, market rates tend to settle around the OCR.

In December, analysts expected the Central Bank to raise the OCR in early 2012 to encourage commercial banks to hold money in their accounts with the Central Bank, which would slow inflationary pressures by encouraging banks to save money, thereby decreasing demand which would lower prices and decrease inflation. However, a January 19th report revealed that the consumer price index (a measure of how much money it costs to buy certain goods and, therefore, a measure of inflation) rose only 1.8%, below the midpoint of the 1% to 3% inflation rate that the Central Bank has targeted in accordance with a Parliamentary mandate to set an inflation target. Since inflation was lower than expected and the economy is still growing at a slow rate, the Central Bank decided not to raise the OCR. By keeping the OCR low, the Central Bank hopes to encourage banks and consumers to continue to spend, rather than save, thereby increasing economic growth and inflation (higher demand will push prices up) to the target level of 2%.

According to Mr. Ballard, inflation will naturally settle at the target level of 2% and economic growth will increase due to the ongoing reconstruction effort in the region of Canterbury. Canterbury has been struck by a series of earthquakes since September 2010, including a February 2011 earthquake that killed 181 people. A large-scale reconstruction effort is scheduled to begin in early 2012, and the additional demand for commodities will likely increase inflation to the 2% target and increase economic activity.

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