Interest rates have been going up in New Zealand since the government started raising them in October 2021.
But why does the government raise and drop interest rates?
And how do they do it?
In this article, I'll explain how interest rates in New Zealand work and how you can use them to be come a better investor.
Why Do Interest Rates Matter?
Interest rates affect everything happening in the economy.
- They affect how much interest you earn on your savings.
- They affect how much your mortgage is.
- They affect the financing for your car.
- They affect everyone with a credit card balance.
- They affect businesses when they need to borrow capital.
Interest rates affect all aspects of commerce, either directly or indirectly.
However, interest rates are not random.
They are very carefully controlled by an institution known as The Reserve Bank Of New Zealand.
The Reserve Bank has the ability to raise or drop interest rates, which has ripple effects through the entire country.
The way they exercise this power is through something called the Official Cash Rate, or the OCR.
The Official Cash Rate
The Official Cash Rate (OCR) is the country's central interest rate.
This is the rate The Reserve Bank lends money at to the big banks, such as Westpac and ANZ.
This obviously influences the rates at which Westpac and ANZ lend money to regular people, like you and me.
If Westpac is borrowing money at 4%, they will probably lend it to me for 6% (I'm simplifying it obviously, but that's the general idea).
Every quarter, the governor of The Reserve Bank reviews the OCR.
If he thinks interest rates are too high, he will reduce the OCR.
If he thinks interest rates are too low, he will increase the OCR.
This change then flows through to the commercial banks, which flows through to the mortgage, savings, loans and credit card markets, and starts to influence changes in your life and my life.
However, what does the governor base his decision on?
What would make him want to increase or decrease interest rates?
It's All About Inflation
Remember when you could buy a bottle of milk for $1?
Nowadays, a bottle of milk costs $5.
This increase in price is known as inflation.
Inflation is not a bad thing. We always want a little bit of inflation.
This is because prices going up is much better than prices going down.
If prices go down, you would never buy anything (why buy it today, when it will be cheaper tomorrow?)
Businesses would never want to open, and markets would crash (would you buy a house today, if you knew it would be 5% cheaper next month?)
Therefore, it's much better when prices go up.
However, prices going up too fast also causes problems.
If prices go up 20% every month, nobody will be able to afford anything, and people's quality of life would deteriorate.
Therefore, we want inflation to stay between a comfortable range.
The Reserve Bank has decided this range is between 1% and 3% per year and keeping it there is their core role.
What is the primary tool they use to achieve this?
Interest rates!
By adjusting interest rates carefully, they are able to control the level of inflation and keep the economy growing sustainably.
When Inflation Is High
Let's start with periods of high inflation.
This means prices are rising too quickly, and The Reserve Bank needs to cool it down.
Prices rising quickly is caused by:
- People spending too much money
- People borrowing too much money
Of course, these two go hand in hand. When you can borrow money easily, of course you will spend more money, and the more being spent in the economy leads to higher prices.
Just think - when everybody wants to buy a house - the prices keep going up, right?
And when nobody wants to buy a house, the prices start to come down.
Therefore, the goal is to get people to start spending less.
To do this, The Reserve Bank will increase interest rates.
When interest rates increase, people will borrow less money (because the interest will be high).
They will also spend less on credit cards (because the interest will be high).
They will also save more (because the interest will be high).
They will also hold off buying a house, or buy a smaller house (because the mortgage interest will be high).
All of this leads to people spending less money, which means inflation will come down.
When Inflation Is Low
When inflation is low, everything works in reverse.
Low inflation is caused by:
- People spending too little money
- People borrowing too little money
Just think - if nobody wants to borrow money - nobody can build new houses or developments.
People won't be buying new homes.
Nobody wants to spend, people want to save instead (because you earn high interest keeping money in the bank).
This means businesses struggle. They need to drop their prices. They don't grow. The economy deteriorates.
During The Great Depression, deflation was one of the big issues.
Prices just kept going down, and nobody had money to spend.
To fix this, The Reserve Bank will decrease interest rates.
People will now stop keeping their money in savings accounts (because interest is low). They will prefer to spend it, or invest in different things like stocks.
They will be happy to borrow money to build or buy new homes (because interest is low).
They won't mind using their credit card to buy things they want (because interest is low).
Businesses will start to grow again and the economy will come back to life.
This all leads to people spending more money, and inflation will rise.
The Interest Rate Cycle
As you can see, this all moves in a cyclical way.
People start spending too much, so inflation gets high, so the Reserve Bank increases the OCR.
This leads to people spending less, and inflation starts to get low, so the Reserve Bank reduces the OCR.
And around it goes.
You can also see this in the history of the OCR.
It has been as high as 8.25%, and as low as 0.25%.
As inflation can never move in a straight line, it will move in cycles instead, with The Reserve Bank being responsible for recalibrating the economy at the peak and trough of each one.
What Can You Do As An Investor?
Understanding this interest rate cycle is extremely important for an investor.
Whenever people talk about understanding "macro", they are referring to macroeconomics which is exactly the type of thing we are talking about here.
As a general rule, during periods of high interest rates, stock and real estate prices fall.
Investors prefer to hold bonds and bank deposits, because they offer a high return at very low risk.
This means during these periods, it's not an ideal time to sell stocks and real estate.
Instead, it can be a great time to buy, as prices are low.
On the other hand, during periods of low interest rates, stock and house prices rally.
This is because people earn no return from leaving their money in the bank, so they prefer to invest it in other assets.
This often leads to bull markets, which can be a great time to own stocks, but also an opportune time to offload stocks you no longer want (as prices will be high).
If you're in the market to sell your house, this can also be a great time to consider it.
Most of you would have seen this play out during the Covid years.
As lockdowns threatened to halt the economy, The Reserve Bank dumped the OCR down to 0.25% (an all time low).
What happened next?
Stock prices and especially house prices in New Zealand surged.
You could barely find a house in Auckland for less than a million dollars.
Obviously, this meant inflation started to get out of control.
The Reserve Bank quickly started raising rates barely a year later.
What happened?
Stock and real estate prices fell quickly and sharply.
People saw six figures fall off their property values within a couple of months.
During this time you would have seen many people surprised at how stock prices and house prices moved.
However, if you understood interest rates and inflation, none of this would have been a surprise to you.
It was basic macroeconomics.
As soon as the OCR got dumped to 0.25%, you would have thought "I bet house prices are going to go way up."
Then as house prices started rising rapidly, you would have thought, "They're probably going to increase interest rates now."
And then as the OCR got hiked, you would have thought "I bet house prices are going to come down now."
And guess what?
That's exactly what happened!
As you can see, even an elementary understanding of interest rates can be extremely valuable as an investor.
If you are able to understand where we are in the macro cycle, your investment decisions will become a lot clearer!
