Official Cash Rate explainer: Why interest rate hikes are the go-to response and will they actually lower inflation?

Kiwis are bracing for more financial pain after the latest Consumer Price Index showed inflation is remaining stubbornly high. 

For the average person, the past year has probably felt like an endless barrage of higher costs. Whether it's food, housing, petrol or your mortgage it can feel like everything is getting more expensive and unfortunately, that's because it is. 

On Tuesday Statistics New Zealand released the CPI figures for the September quarter which showed annual inflation increased by 7.2 percent - down just 0.1 percent from the June peak of 7.3 percent.

The figures were significantly higher than predicted with many experts expecting inflation to be around 6.5 percent. And the higher-than-expected inflation prompted concern and warnings from economists.

It will also most likely prompt another hike to the Official Cash Rate (OCR) which will mean more pain for homeowners.  

Inflation began rising in March 2021 jumping from 1.5 percent to a whopping 7.3 percent in June of the next year. As a result the Reserve Bank of New Zealand (RBNZ) began hiking the OCR - making borrowing more expensive - in an effort to force Kiwis to spend less to reduce demand. 

The RBNZ first increased the OCR by just 25 basis points from 0.25 to 0.50 in October 2021. From there the hikes continued until it hit 3.5 percent just a year later. Further increases are also expected in response to the latest CPI figures. 

But for most people, interest hikes hardly feel like a solution when it just means more financial pressure amidst a cost of living crisis. 

With more people facing mortgage pain, is hiking interest rates the best way to solve inflation or just another excuse to squeeze the average Kiwi out of their hard-earned cash? 

Newshub investigated why OCR changes are the go-to response to inflation and what the alternatives are.

Why is inflation high? 

The first thing to understand is what is actually causing inflation. While it's hard to pinpoint exactly what's to blame, New Zealand has been facing a perfect storm of inflationary pressures over the past year. Including pent-up demand post lockdowns, labour shortages, increased manufacturing costs, supply chain issues from the pandemic and an influx of Government financial support. This culminates in the main driver of inflation - demand outstripping supply. 

The latest CPI figures show housing and household utilities were the main contributors to inflation - increasing by 8.7 percent since September 2021. 

This was mainly influenced by higher prices for home ownership, up 3.3 percent, and property rates and related services, up 7.1 percent.

Transport was the second most significant contributor to the annual increase up 12 percent driven by a 19 percent increase in petrol.

The increase in the cost of food also contributed, with food prices up 8.0 percent annually. The largest contributors to this were grocery food (up 8.0 percent) and fruit and vegetables (up 14 percent).

Why are OCR changes the go-to tool to manage inflation? 

While it might feel like New Zealand has no control over many of the price rises such as petrol, Infometrics principal economist Brad Olsen said we actually have more control than we think. 

Some of the inflation in New Zealand is caused by external forces, such as the war in Ukraine, but Olsen said there are enough things we can control to justify OCR increases. 

For example, Olsen said OCR hikes will bring the cost of building a house down because New Zealand produces most building materials here. 

He said currently we can build roughly 35,000 to 40,000 houses a year but low-interest rates saw building boom with the country currently trying to build more than 50,000.

"So you've got an extra 25 percent on top of normal capacity that we're trying to build. And that has directly been stimulated by very low-interest rates which have put up house prices and the house prices go up, every developer under the sun goes, 'Man, I'm going to make a mint if I build a house and sell it off'. 

"So you've generated a huge amount of additional demand with those lower interest rates, which is what the lower interest rates were designed to do. 

"Now the higher interest rates are designed to kneecap that and say, 'Actually, no, we don't need as much. We can't sustain as much demand for those sorts of products. So we need to bring them down'."

Olsen did concede OCR hikes were a blunt tool for a complex issue but he said they're utilised so often simply because they work - it just takes time. 

"The OCR is an incredibly blunt tool. It doesn't target well either in terms of people or inflation. But importantly while we've talked about fuel, for example, we've seen other costs have gone up quite substantially as well. 

"If it was only one or two products I would very much agree it's difficult to get the OCR to pinpoint into any one of those areas. 

"But 66 percent of all products Stats NZ tracks in the CPI rose in price in the September quarter. That's two-thirds of everything they look at, which means there is definitely enough in there that we can actually influence with the OCR." 

What are the alternatives? 

Olsen said despite the downsides to OCR changes, the alternatives also come with their challenges. 

The biggest challenges to the alternatives are the political nature of them. For example, Olsen said the Government could look at targeted petrol price relief for low-income New Zealanders - which would be more effective than wide-ranging fuel tax cuts - but it's hugely political and comes with administration costs, something that tends to put Governments off. 

Back in March, the Government revealed it was slashing fuel excise tax by 25 cents per litre and halving the cost of public transport for an initial three-month period to help Kiwis struggling with the increasing cost of living. Then, in July, Finance Minister Grant Robertson extended the scheme until the end of January. 

The tax cut was announced after the Government faced increasing pressure over high inflation and the price of petrol skyrocketing above $3 a litre, largely driven by the war in Ukraine. The tax cut was expected to save Kiwis $11 to $17 per average fill-up, depending on the vehicle.

Olsen said the issue with non-targeted policies such as the petrol excise cut is it helps wealthy Kiwis more, which means they keep spending and make inflation worse. 

For example, while fuel tax cuts were meant to make sure Kiwis could take the kids to school and get to work, for middle and high-income earners it meant they could keep doing unnecessary trips. 

"The problem at that point was that those on the lowest incomes couldn't afford the basics and so, therefore, the right policy response if you can achieve it is to target support towards those who need it most to allow for them to do the basics. 

"Which sounds great in practice. But imagine the politics if the government wants to come out and say, 'We're going to provide fuel support to beneficiaries'.

"Then again the administration comes in because there's no easy government apparatus.. unless they're going to give you a very low and middle-income New Zealand, a fuel card all of a sudden that's specially designed to give them cheaper fuel, which obviously has very high admin costs. It's pretty easy for them to just say, 'We'll lop $0.25 a litre off fuel tax. So there's an efficiency versus targeting question that always comes up with these things as well." 

Olsen said another option is tax changes to offer relief to the lower income earners while targeting wealthier Kiwis with capital gains and wealth taxes. But that presents multiple challenges, firstly it is hugely political and secondly changing tax rules regularly is a fraught exercise, he warned. 

"You don't want to vary your tax settings every year or every three months or something like that, you want to set them to a degree. So they're not a great tool to be able to move."

Olsen said another option is the Government could simply ask people to spend less but the likelihood of that working is slim to none. 

"You could ask households and businesses nicely to not buy as much stuff… You could, but they won't. It would be nice [but] it just doesn't happen."

Another issue with most alternatives is targeting policies is something most politicians are actually "fairly poor at", he added. 

The challenges of targeting policies is a concern shared by New Zealand Initiative chief economist Eric Crampton who said it is fraught with issues. 

"If the Bank expects that, a year from now, too much money will be chasing after too few goods, raising the interest rate reduces demand across the board. Investment projects, whether in construction or otherwise, that made sense at lower interest rates make less sense at higher interest rates. 

"Increasing interest rates means the Bank does not have to pick and choose where to try to reduce demand, which would be terribly fraught," he said. 

But Crampton said there are added challenges the RBNZ is facing which add extra challenges to managing inflation simply by hiking interest rates. 

One of those is the real possibility of a global recession next year - which puts the RBNZ in a "difficult spot". 

"It is not crazy to expect a global recession in the next year through the combination of global monetary tightening and the effects of the war in Ukraine. Energy prices in Europe all on their own are likely to spark recession there. 

"A central bank expecting global recession would not normally want to be tightening monetary conditions. But both inflation and inflation expectations have been becoming unhinged," he warned. 

Crampton pointed to an RBNZ survey released earlier in the month which showed less than 5 percent of respondents were “extremely confident” it would get inflation back within its target range by 2024. 

It also showed only 20 percent of respondents were “somewhat confident”. And about sixty to seventy percent of respondents were either “not at all confident” or “a little confident”.

"It means that the Bank not only has to fight inflation but also has to fight to restore confidence in its commitment and ability to achieve its target. 

"A Bank with stronger inflation-fighting credibility could afford a more cautious approach in response to global uncertainty," he said. 

Will OCR increases actually get inflation under control? 

OCR hikes can be an unpopular method of controlling inflation, mostly because they put financial pressure on households and are pretty unpleasant. 

And with inflation remaining high despite huge increases, many Kiwis will be wondering just how long and high the RBNZ will take interest rates. 

Brad Olsen acknowledged the discomfort but offered assurances it will work - it just might take some time. 

"New Zealand was the first in the world to inflation target back in the 1990s. It worked then and it has provided, generally speaking, price stability over the last 30 to 32 years. 

"I feel like we've got to back it for long enough to do its job now. It's uncomfortable, it takes a bit of time [but it works]."

He also pointed out Kiwis don't question its effectiveness when interest rates are low so as unpleasant as it is, it's necessary. 

"It will take time and it will certainly cause some huge challenges. But it does feel like the best way to go about it."

"If we're happy to take the wins of low-interest rates last year, we've got the pain of higher interest rates this year. That's on a broad economic level.

"[But] it's those young people who have got into the housing market in recent times, gotten themselves right up to the hilt in debt at very low rates that are now getting punished the hardest. 

"So there are definitely distributional issues and we're not blind to them. But there are wider concerns about inflation that sort of trump those," he said. 

Where to from here? 

New Zealand is facing a long battle to get inflation back within the RBNZ's 1 to 3 percent target with most economists predicting OCR will continue to rise into next year. 

This means homeowners should expect their mortgages to get more expensive for some time to come. 

Off the back of the higher-than-expected CPI data, ASB is now predicting a 75 basis point increase in the OCR in November, followed by a 50 basis point hike in February and a final lift in April of 50 basis points. If that plays out it would take the OCR to a peak of 5.25 percent. 

It's a view shared by Jarden investment strategist and economist John Carran who said a 50 basis point hike is "almost certain" in November. 

"There are likely to be some on the Monetary Policy Committee that push for a 75 basis point OCR rise at the next meeting, given that option was discussed at its most recent meeting.

"If the September quarter labour market data shows continued heat with faster-than-expected wage growth, we would err towards expecting 75 basis points too.

"However, at this stage, we would expect the Committee to stick to a 50 basis point hike in November but will likely indicate in its November Monetary Policy Statement further chunky OCR rises through the first half of 2023."

But Carran expects OCR will peak slightly lower than ASB predicting it to hit 4.75 percent in the middle of next year.