It happened. Again. Yesterday, the Reserve Bank increased the OCR. While an increase was expected, the size of the jump surprised economists. It was an 0.5% increase rather than the projected 0.25%.

National’s Nicola Willis called it a “punch in the guts” for Kiwis with mortgages.

But is it the knockout blow to interest rates you might think? Here’s why interest rates won’t increase (at least not by that much). The jump is to stop banks reducing their interest rates.

Higher OCR does not necessarily equal higher interest rates

Many people think a higher OCR = higher interest rates. That’s not always how it works.

OCR hike does not equal interest rate hike. Six weeks ago, the Reserve Bank lifted the OCR by 0.5%. But since that increase, interest rates have come down:

• ASB’s one-year rate fell by 0.2%
• BNZ has been offering cracker deals at 4.99%.

The purpose of the OCR increase is to stop that from happening. The Reserve Bank wants banks to keep mortgage interest rates where they and increase their deposit rates.

The Reserve Bank’s statement says that the Monetary Policy Committee was comfortable that current lending rates will ensure that core inflation will begin to moderate. They point to the fact that wholesale interest rates have fallen since the February statement and believe this could put downwards pressure on lending rates.

The Reserve Bank thinks the current mortgage interest rates are enough to tackle inflation. The increase in the OCR is to keep these rates where they are.

Banks are reducing their rates because their costs are down

Banks don’t (usually) borrow cash from the Reserve Bank to lend you money for your mortgage. Instead, they get the money from:

• their own funds
• wholesale money markets and from
• term deposits.

And since the most recent OCR increase, the one-year wholesale interest rate had gone down. It was getting cheaper for the bank to borrow from someone else and lend to you for your mortgage.

This is what’s allowed banks to put their interest rates down (even though the OCR went up).

Since yesterday’s announcement, the 1-year wholesale rate has returned to where it was after the previous OCR announcement.

On top of this, the banks have seen their margins increase. This is partly because mortgage interest rates have risen faster than term deposit rates. That increase in margin allows the banks to decrease their mortgage interest rates sooner than the Reserve Bank wants.

And that’s why the central bank has surprised us. If they only increased the OCR by 0.25% (as expected) they’re worried that:

• mortgage interest rates will fall too soon
• that we’ll start spending more
• and that inflation will stick around for longer.

What will happen to interest rates?

We’ve predicted that the one-year mortgage interest rate will hit 7% in April.

If you compare that to ANZ’s most recent forecast, they suggest that interest rates have already peaked at around 6.6%. But we’re sticking with our 7% projection for the 1-year rate. And are not changing this projection based on yesterday’s hike.

That’s because while the Reserve Bank surprised us with its increase; the endpoint is still the same. The Reserve Bank expects the OCR to peak at 5.5% later in May. That’s the same as what they’ve been projecting for the last 4.5 months.

The endpoint hasn’t changed. We’ll just get there faster than first thought. And because of this, I’m not expecting a significant jump in interest rates.

But of course, that’s all based on the current data I have available today. New inflation data comes out in two weeks. That data will influence what happens to interest rates over the next year.