Money · Credit · New Zealand · Part 24
If banks can create credit, why do interest rates matter so much?
Because the power to create a deposit does not remove the price of credit, the cost of funding, the risk of lending or the willingness of borrowers to take on debt.
By this point in the series, we know something important.
A commercial bank does not normally need to find somebody else's existing deposit before it can make a new loan.
When the loan is approved, the bank can create the corresponding deposit.
So why does the Official Cash Rate matter?
If banks can create credit, why should a change of 0.25 percentage points at the Reserve Bank affect mortgages, business investment, house prices, jobs and inflation?
Because the OCR does not operate by rationing out a fixed quantity of money.
It changes the price and financial conditions surrounding money and credit.
The Reserve Bank does not tell banks how many dollars they may create. It changes the conditions under which creating, funding and holding credit is profitable and desirable.
The OCR is currently 2.5%
As at 29 August 2026, New Zealand's Official Cash Rate is 2.50%, following the Reserve Bank's 8 July decision.
The Bank describes the OCR as its main tool for keeping inflation between 1% and 3% over the medium term.
Reserve Bank — The Official Cash Rate ↗
But the OCR is not the mortgage rate.
It is not the business-loan rate.
And it is not a legal maximum or minimum interest rate banks must charge customers.
It is the anchor around which short-term interest rates in the financial system are organised.
Start inside the Reserve Bank
Banks and other eligible institutions hold settlement accounts with the Reserve Bank through the Exchange Settlement Account System.
These balances are used to settle payments between institutions.
New Zealand currently operates a floor system for monetary-policy implementation.
The Reserve Bank remunerates settlement cash balances at the OCR and structures its facilities so short-term market rates trade close to the policy rate.
Reserve Bank — Monetary policy implementation framework ↗
That establishes the starting price for very short-term New Zealand-dollar money.
Why would that affect a bank?
Imagine a bank deciding whether to:
hold settlement cash,
buy a short-term security,
make a mortgage,
make a business loan,
or place funds elsewhere.
Those assets have different risks and maturities.
But the return available on very safe short-term money provides a reference point.
If the OCR rises, the return available on settlement balances and very short-term instruments rises.
A private loan therefore has to compensate the bank appropriately for:
credit risk,
capital usage,
liquidity,
operating cost,
term risk,
and profit margin.
If the risk-free or near-risk-free alternative becomes more expensive, private credit cannot be priced as though nothing changed.
The OCR then enters wholesale financial markets
The Reserve Bank says the OCR has its most direct effect on short-term wholesale market interest rates.
Reserve Bank — Monetary Policy Handbook, Chapter 5 ↗
Those markets include bank bills, swaps and other institutional interest rates.
The Reserve Bank publishes these rates daily because they form an important part of the monetary-policy transmission system.
Reserve Bank — Wholesale Interest Rates ↗
But something else matters too:
expectations.
A two-year mortgage depends on more than today's OCR
Suppose the OCR is 2.5% today.
A bank considering a two-year fixed mortgage needs to think about where short-term rates may be over the next two years.
If markets expect the OCR to rise substantially, two-year wholesale rates can rise before the Reserve Bank actually changes today's OCR.
If markets expect future cuts, fixed mortgage rates can fall before an OCR cut occurs.
The Reserve Bank's Monetary Policy Handbook explains that longer-term rates reflect expectations about the future path of short-term interest rates across the yield curve.
Reserve Bank — Monetary policy transmission ↗
The OCR is one rate today. Monetary policy works through an entire expected path of interest rates into the future.
Then we reach bank funding costs
A bank creates deposits through lending.
But it still needs a sustainable funding structure.
Banks fund themselves through combinations of:
transaction deposits,
savings accounts,
term deposits,
domestic wholesale funding,
offshore wholesale funding,
and shareholder capital.
Those funding sources have prices.
When the OCR and wholesale rates rise, banks may have to offer higher deposit rates to retain funding and pay more to issue wholesale debt.
That changes the economics of making a new loan.
The Reserve Bank has measured the pass-through
A June 2026 Reserve Bank discussion paper examined more than two decades of weekly data from ten New Zealand banks.
It found that monetary-policy changes substantially pass through to advertised mortgage and deposit rates, but not instantaneously.
In the week of an OCR announcement, only around 4% to 11% of the policy change was reflected in retail rates.
After roughly 20 to 25 weeks, pass-through reached around 65% to 75% for most products.
At longer horizons, the researchers could not reject full one-for-one pass-through for most mortgage and deposit rates.
Reserve Bank — Responses of deposit and mortgage rates to monetary policy changes ↗
This is strong evidence against two simplistic claims:
“The OCR directly sets mortgage rates.”
It does not.
“The OCR does not matter because banks set their own rates.”
That is also wrong.
Banks still set their own retail rates
The Reserve Bank explicitly says banks decide their own rates based on factors including:
loan risk,
operating costs,
competition,
the exchange rate,
funding conditions,
and expectations for future OCR decisions.
Reserve Bank — How the OCR affects interest rates ↗
So a bank's mortgage rate can move without an OCR decision.
And an OCR movement does not guarantee an identical movement in every lending rate.
We saw that in 2026
The May 2026 Monetary Policy Statement reported that retail rates had risen, but by less than wholesale rates.
Most term-deposit rates had risen around 20 to 40 basis points since the February Statement, while fixed mortgage rates across six months to five years had risen around 5 to 40 basis points.
The Reserve Bank attributed part of the incomplete pass-through to changes in the relative cost of bank funding and cautious retail repricing during volatile financial-market conditions.
Reserve Bank — Monetary Policy Statement May 2026 ↗
That is why the transmission mechanism needs to be understood as a chain, not a switch.
Then the borrower enters the picture
Suppose a household can afford mortgage repayments of $4,000 per month.
At a lower interest rate, that income can support a larger loan.
At a higher interest rate, the same household income supports a smaller loan.
The bank may still have the accounting ability to create a larger deposit.
But the borrower may no longer pass affordability tests or want the debt.
This is one of the most important limits on bank credit creation.
Banks can create deposits. They cannot create borrowers who can afford any interest rate.
The same applies to businesses
Suppose a company is considering a new factory expected to produce an 8% return.
If financing costs 4%, the investment might appear attractive.
If financing costs 9%, the project may no longer clear the company's hurdle rate.
The creditworthy project itself can disappear because the cost of capital changed.
So higher interest rates reduce credit creation partly by reducing the number of investments worth financing.
Interest rates also change existing borrowers' cash flow
New Zealand has a large share of mortgages on fixed terms that periodically reprice.
That means OCR changes do not hit every household immediately.
They work through as borrowers refix.
The Reserve Bank's May 2026 Statement estimated the average yield on the mortgage stock at around 4.9% in March 2026 and noted that, under then-current wholesale pricing, it could rise to around 5.4% by March 2027 as borrowers refixed.
Reserve Bank — Mortgage repricing, May 2026 ↗
Higher repayments leave households with less income for other spending.
Lower repayments do the opposite.
This is one of the ways monetary policy changes aggregate demand.
Savers experience the opposite side
When deposit rates rise, savers can earn more by leaving money in term deposits or other interest-bearing assets.
That creates two effects.
Saving becomes more attractive relative to immediate consumption.
And some savers receive more interest income.
The overall effect depends on who is borrowing, who is saving, how they respond, and how quickly banks pass rates through.
Monetary policy is therefore partly a redistribution of cash flows between debtors and savers.
Asset prices are another transmission channel
Interest rates affect the present value of future cash flows.
When discount rates rise, assets whose value depends on future income can become less valuable, all else equal.
This can affect:
houses,
commercial property,
shares,
bonds,
and businesses.
Changes in asset values can then affect collateral, household wealth, confidence and willingness to borrow.
This matters in a credit system where collateral values influence lending decisions.
The exchange rate is another channel
Interest-rate expectations can influence demand for New Zealand-dollar assets.
All else equal, relatively higher New Zealand interest rates can make NZ-dollar financial assets more attractive to investors.
That can put upward pressure on the exchange rate, though many other forces affect currencies.
A stronger exchange rate can reduce the New Zealand-dollar price of imports and make exports less competitive.
A weaker exchange rate can do the reverse.
The Monetary Policy Handbook includes the exchange rate as an important transmission channel from monetary policy to activity and inflation.
Reserve Bank — Monetary Policy Handbook ↗
Then there is expectations and confidence
Monetary policy works partly before anyone's mortgage actually reprices.
Businesses make investment decisions based on expected future financing conditions.
Households decide whether to buy property based partly on expected rates.
Banks price fixed lending based partly on expected wholesale rates.
Financial markets move as expectations change.
That is why Reserve Bank communication itself matters.
A credible signal about the likely future path of policy can shift market rates today.
So does the OCR “control the money supply”?
Not in the old mechanical sense of choosing an exact quantity of broad money and forcing the banking system to deliver it.
Modern New Zealand monetary policy primarily operates through the price of short-term money and the transmission of financial conditions.
Banks and customers then make lending, borrowing and saving decisions within those conditions.
The resulting amount of broad money is endogenous to those interactions.
This is consistent with the Reserve Bank's explanation that broad money is largely created through commercial-bank lending and depends on interactions between banks and their customers.
Reserve Bank — Money Creation in New Zealand ↗
The Reserve Bank influences the price of credit. Banks decide whether to supply it. Borrowers decide whether to demand it. The economy determines what happens next.
Why not simply set interest rates to zero forever?
Because cheap credit changes behaviour.
More borrowing can increase spending.
Asset demand can rise.
Weak projects can appear financeable.
Savers receive lower returns.
The exchange rate can move.
And if aggregate demand persistently exceeds the economy's capacity to produce goods and services, inflation can rise.
Very low rates can be appropriate when demand is weak and inflation is below target.
They are not a permanent source of free real resources.
Why not set rates extremely high and stop inflation immediately?
Because monetary policy has costs.
Higher interest rates can reduce investment, construction, household consumption and employment.
They increase debt-service burdens.
They can expose weak borrowers and financial vulnerabilities.
And their effects arrive with lags.
The Reserve Bank therefore has to judge how much restraint is needed to return inflation to target without imposing unnecessary instability on output and employment.
The delays make monetary policy difficult
The Reserve Bank notes that the full impact of an OCR change can take months or even years to flow through the economy.
Reserve Bank — OCR transmission lags ↗
That happens because:
fixed mortgages reprice gradually,
term deposits mature at different dates,
business investment takes time to change,
households adjust spending slowly,
and wage and price decisions respond with delay.
Monetary policy therefore has to be forward-looking.
If the Reserve Bank waited until every inflation effect was visible, policy would always arrive late.
Interest rates do not solve supply constraints directly
This is another crucial distinction.
A higher OCR cannot produce:
more electricity,
more houses,
more nurses,
more ports,
more roads,
or more skilled engineers.
Its main job is to influence demand and inflation pressure.
If inflation is caused partly by a genuine supply shortage, monetary policy may restrain demand while the underlying supply problem still needs a separate solution.
This is why the investment arguments earlier in the series matter.
Could productive investment reduce the need for future monetary restraint?
Potentially, over time.
If investment expands electricity supply, transport capacity, housing capacity, technology or labour productivity, the economy may be able to produce more before running into inflationary pressure.
That does not mean every infrastructure project lowers inflation.
Construction itself can increase demand in the short term.
But successful supply-expanding investment can improve productive capacity over a longer horizon.
The timing distinction matters.
A useful transmission map
I would describe the mechanism like this:
OCR → settlement and overnight rates.
Expected OCR path → wholesale yield curve and swap rates.
Wholesale rates + deposit competition + risk + operating costs → bank funding costs.
Funding costs + credit risk + capital + competition + margin → retail lending rates.
Retail rates → borrowing, saving, refinancing and investment decisions.
Those decisions → spending, asset prices, employment, exchange rate and demand.
Demand relative to productive capacity → inflation pressure.
My conclusion
Banks can create credit.
But they cannot create it without regard to price.
The OCR influences the opportunity cost of money, banks' funding environment, wholesale rates, retail lending rates and the willingness and capacity of customers to borrow.
It changes the economics of both sides of the credit transaction.
That is why an institution that does not directly approve a single household mortgage can still exert enormous influence over mortgage creation across the country.
The OCR does not turn bank money creation on or off. It changes the price at which the entire credit system has to make its decisions.
Next
That leads directly to the next question:
Why does the Reserve Bank target inflation instead of house prices?
Part 25 will examine the 1% to 3% inflation target, CPI, asset prices, financial stability, loan-to-value and debt-to-income restrictions, and why controlling the price of houses is a different policy problem from maintaining price stability across the economy.
Primary sources
Reserve Bank — The Official Cash Rate ↗
Reserve Bank — Monetary Policy Implementation Framework ↗
Reserve Bank — Monetary Policy Handbook ↗
Reserve Bank — Responses of Deposit and Mortgage Rates to Monetary Policy Rate Changes ↗