How does increasing the OCR decrease inflation?
In 2022, inflation leapt to 7.3%.
The Reserve Bank responded by hiking the OCR up to 5.5% from 0.25%. A massive 5.25% jump!
Since then, inflation has gone down as low as 2.2%.
But, how did that happen? Why did raising the OCR mean prices stopped going up as fast?
To understand that … you need to ask yourself: “What makes inflation go up?”
Us economists often say – “It’s too much money chasing too few goods.”
Said more simply, interest rates were too low coming out of Covid-19. So, all of us Kiwis were spending lots of money.
So businesses started putting their prices up without losing too many sales.
That is inflation. Businesses putting up their prices.
What’s the Reserve Bank to do? They hike up the OCR. That increase both mortgage and term deposit rates.
That does two things:
- Borrowers have to pay more to the banks on their mortgages. So, people with mortgages have less money to spend.
- And then savers get a better return on their savings. So people with savings, are encouraged to lock up their money in a term deposit, rather than spending.
Together, that reduces spending in the economy.
That makes life tougher for businesses. They can’t increase their prices as fast, because there aren’t as many people willing to spend.
So inflation goes down.
