Reserve bank governor Adrian Orr (Image: NZ Super Fund)
Reserve bank governor Adrian Orr (Image: NZ Super Fund)

MoneyMarch 16, 2020

What the whopping Covid-cut to the Official Cash Rate means

Reserve bank governor Adrian Orr (Image: NZ Super Fund)
Reserve bank governor Adrian Orr (Image: NZ Super Fund)

In a surprise move this morning, the Reserve Bank has slashed the Official Cash Rate to just 0.25%, down from 1%. So what does that mean for you, and why has it happened now?

Just quickly – what is the official cash rate?

The OCR is the interest rate at which the Reserve Bank lends money to commercial banks. When it gets cut, it basically means the cost of money becomes cheaper, because it forces those commercial banks to then lower the rate of interest they charge customers. In doing so, the hope is that economic activity will be given a boost.

Think about it this way: Jane wants to start a small building company. But to do so, she’ll need to borrow money to buy tools and hire staff, to then do the work which will bring in money from customers – that’s all activity which flows through to the wider economy. So to borrow that money, she goes to a commercial bank. When the OCR is lower, the interest rate that commercial bank charges in order to lend is also lower, and so it makes sense that more of this sort of activity-enabling borrowing will happen.

What’s happened to it?

In the space of just a couple of weeks, the altered economic outlook for New Zealand has caused the Reserve Bank to seriously and rapidly reassess its approach. On February 12, the Official Cash Rate was held at 1%, which at the time was a record low. At the time, governor Adrian Orr said that the underlying economic picture appeared to be improving, and rate cuts were on hold for the foreseeable future. But there was also a note in that announcement that they’d keep an eye on what the coronavirus would mean for the economy.

As it turns out, that foreseeable future is now radically different already. With markets crashing around the world because of Covid-19 outbreaks and accompanying public health restrictions, and a recession now basically certain to hit New Zealand, Orr has moved to cut. He did so well before any update was scheduled to be made, surprising many with both the timing and the scope of it.

And now the OCR is at a way lower level than a previous record low? 

Correct, and it’s going to stay there for a long time. According to today’s announcement from the Monetary Policy Committee, it will be held at that level for at least 12 months. There isn’t really much further that they can move in this area – what is known as ‘monetary policy’. So instead, the Reserve Bank reckons that future steps to stimulate the economy should take place in the realm of ‘fiscal policy’ – in other words, government spending.

On that, the government has a massive economic support package coming tomorrow, aimed primarily at protecting jobs amid the wider economic slowdown.

But if it can’t go any lower, what then?

There are other tools that can be used for such a situation. One of them is known as ‘Quantitative Easing’ – you might have seen that around recently in memes with the tagline ‘money printer go brrrrr.’ The common fear with QE is that by pumping up the supply of money artificially is that it will also make inflation go wild – but inflation has been really low for a long time now anyway, so it may not be quite such a big concern.

The RBNZ today suggested that rather than further rate cuts, if there needs to be more stimulus on their end, they’d rather do it through the purchase of government bonds, which is effectively how QE works in practice.

Is there a risk of the banks collapsing?

Not according to the Reserve Bank. In their statement today, they noted that “New Zealand’s financial system remains sound and our major financial institutions are well capitalised and liquid. The Reserve Bank is also ensuring that the banking system continues to function normally.”

One interesting provision in the Reserve Bank’s announcement today was the suspension of new capital requirements for banks. Because commercial banks lend out far more money than they actually hold, the RBNZ had been intending to force them to hold more capital relative to their lending, to basically prevent them going belly-up in case of a 2008-style economic credit crunch. The commercial banks weren’t happy with that, as it would have significantly increased their costs, and meant they probably would have lent out a lot less money. So by suspending the new capital requirements, the RBNZ is effectively telling the commercial banks that they’re strongly expected to pass on the OCR cut in the form of lower interest rates.

Will all of this save the economy?

At this stage, it’s impossible to say with any certainty what the economic future holds, simply because we don’t know what will happen next with the coronavirus outbreak. What we can say is that the people who are tasked with staving off economic catastrophe are being proactive about their jobs right now, and treating this situation in unprecedented new ways.

Keep going!