Connecting Fed Rate Cuts & Credit Card Interest Rates
Whatever the interest rate on your card, it will probably fall when the Fed cuts interest rates, unless it is a 0% intro Annual Percentage Rate (APR) credit card or you are still in another type of introductory low rate period. Similarly, the APR on your credit card will likely rise when the Fed raises rates. Here’s how this works.
The Fed’s main job is to adjust interest rates to meet its long-term inflation target of 2% per year. If inflation looks as if it’s rising above target, the Fed may raise rates; if inflation is set to sink below the target, the Fed may cut them.
But the Fed doesn’t directly control interest rates, including the prime rate. Instead, it sets a “target range” for the Federal Funds Rate, which is the rate at which banks lend to each other for short-term loans they may need. It’s typically about three percentage points lower than the prime rate, and the lowest cost of funding for banks.
So, when the Fed cuts interest rates, what it actually does is lower the target range for the Federal Funds Rate. For example, if the target range is 1.00%–1.25%, and the Fed cuts rates by 0.25%, the target range falls to 0.75%–1.00%. The Fed uses the theory of supply and demand to get interest rates to fall into its desired target range: it buys and sells securities, which increases or decreases the total supply of money available in the economy. But it doesn’t aim to hit the bottom of its desired range. Instead, when headlines say “Fed cuts interest rates to 0.75%,” the Federal Funds Rate is actually somewhere between 0.75% and 1.00%.
Banks and credit card companies earn their keep by charging higher interest rates on credit cards and other lending than they pay on deposits and other forms of funding. When the Fed reduces its target range, banks’ cost of funding falls. Usually, they pass this on to customers by cutting the prime rate, which reduces interest rates on loans and credit cards. Because credit cards typically have variable interest rates, when the Fed cuts interest rates, chances are that lower interest on credit cards may be one result.